Blockchain Audit, Risks and Controls

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  • AuditNet

    In October, AuditNet will add the following Blockchain Risk Identification Checklist to the audit templates. Here is the checklist in advance for AuditTalk members.


    New technologies carry potential downsides that need to be identified and managed. This is especially true when that technology is not merely an overlaying application but rather a core part of the organization’s underlying IT infrastructure, as is often the case with blockchain.

    This checklist covers some common potential risks and missteps associated with the deployment of blockchain technologies. Note, however, that this list is not meant to be exhaustive. With that in mind, project managers should view the information as generic guidance and work with relevant internal stakeholders, such as cybersecurity, internal audit, finance, compliance, legal, operations, and information technology teams to identify and prioritize risks that are significant for their deployment and develop mechanisms to manage the risks proactively.

    Risk identification checklist
    Following is a checklist of potential risks and missteps often associated with blockchain deployments. While all blockchain use cases may not involve digital assets, this checklist also outlines risks pertaining to use cases that involve digital assets. Note that this list includes some of the prominent risks but is not meant to be exhaustive. The checklist items are neither ranked in order of priority nor equally weighted. The probability of risks manifesting into actual events are dependent on a range of factors.

    Organizations should treat this checklist as generic guidance, and work with relevant internal stakeholders to identify, prioritize, and manage the risks relevant for their project proactively. The scope of this module doesn’t include guidance on enterprise risk management programs.
    Also note that some of the specific risks mentioned below – for instance, Cybersecurity – are covered in greater detail in other modules in this toolkit. Be sure to refer to the modules dedicated to those issues as required by the needs of your project.

    Technology risks

    Effective development and deployment of blockchain-based solutions require the identification and addressing of a list of technological risks and challenges. The list includes privacy of data and transactions on the blockchain, security risks, performance-related limitations of the underlying blockchain platform, and integration-related issues with other enterprise systems.

    Data privacy risks

    Could flaws in the blockchain-based system design lead to non-compliance with regulations or confidentiality agreements governing data? For instance, does the application involve personally identifiable information (PII) or confidential freight data? Do the requirements permit on-chain storage of data, or does it need to be stored off-chain?
    Does the application incorporate appropriate controls across the data lifecycle (e.g., collection/creation, storage, usage, and sharing/transfer as data is shared across the blockchain nodes)?
    Is there a risk of exposure of sensitive data due to inadequate policies, procedures, standards and guidelines for data encryption and obfuscation?
    Could incoming data potentially be inaccurate? If so, how to identify and correct errors?
    Is the blockchain system required to comply with “right to be forgotten” regulations? If so, is it in conflict with potential immutability of data on a blockchain?

    Performance-related risks

    What is the performance-related limitations of the underlying blockchain platform relative to the proposed blockchain use case (e.g., transaction throughput, settlement time, and availability)?
    Could the blockchain platform being used be suboptimal in terms of developer support and/or vendor lock-in?
    Is the selected blockchain protocol interoperable with other protocols required by the project?
    For further details on blockchain protocol interoperability with other protocols, see the module Interoperability.

    Security risks

    Like other technology-enabled system, blockchain systems also need to be assessed for a variety of cyber security risks, such as confidentiality of users, security of private keys that secure access to digital assets, and endpoint protection. For further details on security risks, see the module Cybersecurity.

    Integration-related risks

    Will there be integration issues with any mission-critical legacy systems used within the organization?
    Are there standards available for integration of blockchain applications with enterprise systems?
    Is there appropriate integration testing at both the participating entities and the blockchain consortium entity?
    Could lack of common data architecture and data directory lead to enterprise systems feeding misaligned data to the blockchain system?

    Operational risks

    Implementation of blockchain-based applications, especially in a consortium of several organizations, is complex and involves addressing several operational risk issues such as governance, controls, auditability of blockchain transactions, and proof of assets ownership.
    Governance and controls risks
    Is the legal entity structure of the blockchain consortium appropriate for tax implications and benefits of the participants?
    Could decision making within a consortium be suboptimal due to lack of proper structure and processes?
    Are there appropriate controls to mitigate conflicts stemming from decentralized accountability and shared ownership?
    Is there a lack of structure and policy in the consortium to onboard new members and accept new use cases?
    Have the smart contracts been audited to avoid incorrect implementation of business or legal arrangements?

    Auditability Risks

    Is there enough technical experience or capability in conducting IT/technology audit of the blockchain application or platform?
    Will management and/or auditors be able to obtain information required to support financial statement disclosures?
    Will management be able to value digital assets in accordance with relevant accounting policies?
    Is there risk of a “hard fork” of the blockchain to modify past transactions, allow previously disallowed transactions, or bring about other structural changes to the blockchain?

    Asset ownership risks

    Is there a risk of theft or loss of digital assets because of the irreversible nature of transactions in the blockchain protocol?
    How is the real-world change of ownership of assets made consistent with the change reflected on-chain?
    Can real-world identity be adequately confirmed to establish ownership of assets when required? Is there additional complexity due to the potential anonymity of participants on the blockchain protocol?
    Are adequate industry standards available for designing interoperable blockchain-based tokens?

    Legal and regulatory risks

    Blockchain as a technology may not be regulated, but applications built using blockchain technology will need to adhere to relevant regulations, such as the European Union’s General Data Protection Regulation (GDPR) relating to data protection and privacy. Legal and regulatory risks include uncertainty around cross-jurisdictional regulations, anti-trust violations, smart contract enforceability, anti-money laundering (AML) and know-your-customer (KYC), and intellectual property (IP) protection.

    Legal and regulatory risks

    What are potential legal and regulatory risks and challenges to be anticipated with the deployment of this blockchain-based application? These may include uncertainty around cross-jurisdictional regulations, antitrust violations, smart contract enforceability, anti-money laundering (AML) and know-your-customer (KYC), and intellectual property (IP) protection.
    Could there be legal conflicts between consortium participants or consumers due to unclear legal liability in a permissioned network for cases such as data breach or smart contract errors?
    Is there risk stemming from regulatory uncertainties related to blockchains and related systems, especially across jurisdictions? Different data privacy and security regulations may apply in different jurisdictions around the world, for example.

    Antitrust risks

    Are there safeguards against a blockchain consortium fixing or manipulating prices to gain competitive advantage?
    Could significant members within a blockchain consortium collude, leading to manipulation of services offered to smaller entities or preferential treatment of certain transactions?
    Are there antitrust risks arising from a certain blockchain consortium potentially pulling a significant share of the market into a closed ecosystem, thus causing disadvantage to competitors and consumers?
    Could a large blockchain consortium disfavor competitors, such as by excluding them, offering discounts to selected partners, or punishing competitors using alternative private currencies?

    AML and KYC risks

    Is the blockchain system subject to compliance for AML or KYC regulations governing money service businesses?
    Are rigorous “know-your-supplier” checks required for compliance?
    Are there safeguards against payment being made to or from parties or countries subject to international sanctions, or with “politically exposed person” status?
    Could decentralized applications (Dapps) be deployed that accept or transmit value without necessary controls and compliance programs?
    Are requisite surveillance and monitoring controls implemented to detect and prevent money laundering activities?
    Are there additional risks due to anonymity of transactions and identities on the blockchain?

    Financial risks

    A common aim of blockchain deployment is to facilitate transfers of value. A variety of financial risks need to be considered while designing such blockchain applications, platforms, and infrastructure, such as potential for financial loss, transaction settlement finality, consortium funding-related risks, and intellectual property protection issues. In addition, there are several accounting and reporting challenges that should be considered when depending on blockchain-based applications for financial transactions and for information used in financial reporting.

    Funding related risks

    Could funds run short to operate the consortium due to inappropriate choice of funding model? Will an initial coin offering (ICO), member fee structure, equity funding among partners, government grants, or some other funding sources be used?
    Does the funding model of the consortium clearly define which participating entity will fund what?

    Benefit related risks

    Has a revenue and other benefits sharing model been defined amongst entities of the blockchain consortium?
    Might participants be subject to financial loss due to absence of a trusted intermediary in blockchain-based business models to remedy errors or revert transactions? Could an alternative method of resolving disputes be created?

    Internal control risks

    Is there a risk of financial loss due to the absence of a trusted intermediary in blockchain-based business models to remedy errors or revert transactions?
    Is there risk of financial loss due to incorrect representation of commercial contracts in the smart contract code?

    Accounting and financial reporting risks

    If digital assets (e.g., cryptocurrency tokens) are used to transact in the blockchain system, is there a risk of incorrect accounting due to lack of standard guidance on accounting for digital assets?
    Is there a risk of misinterpretation of existing accounting literature while accounting for digital asset transactions?
    Could underlying rights and obligations associated with digital assets be potentially misunderstood?
    When the use case involves digital assets, is technical experience available to determine the fair value of digital assets?
    Is technical experience available to perform traditional financial reporting activities (e.g., complexity involved in reconciliation of internally held records with blockchain data)?
    Is there a risk of noncompliance due to continuing evolution of market and industry and changing requirements from regulators and standard setters?
    Is the management equipped to mitigate new and unforeseen forms of related party transactions or fraud schemes in financial reporting?
    Is there a mechanism to assess the beneficiaries of services provided by third parties who are obligated to remain objective of one or more entities of the blockchain network?
    Can unreliability of blockchain systems render blockchain data and digital assets inaccessible?

    Consortium intellectual property protection risks

    Does the blockchain consortium have an appropriate intellectual property (IP) management model? For instance, IP may be owned by the lead members, by a separate consortium legal entity, or be provided under open-source license.
    Has an appropriate IP monetization model been established?
    Could there be IP infringement within a consortium or by other consortia that member organizations participate in?
    Are there appropriate controls in place governing how members and third parties can contribute or enhance IP assets on the blockchain?
    If the application is based on a protocol that is open source – for instance, Bitcoin or Ethereum – is there a risk around non-compliance with underlying open-source license terms?
    Could there be a lack of support from the members in the IP development or maintenance lifecycle?
    If the consortium legal entity should become insolvent, are there contingency plans regarding custody and maintenance of IP? For example, it could be that the IP is held in an escrow account in such a scenario.
    For different IP ownership modules to consider, see focus area Intellectual property in the module Consortium Governance. For core legal and regulatory concerns and questions around IP in blockchain, see focus area Intellectual property in the module Legal and Regulatory Compliance.

    Strategic risks
    Adoption of blockchain technologies and business models is a strategic bet for organizations. It thus entails a range of strategic questions, such as defining the applicable value proposition, brand and reputation management, and handling change management.
    Value proposition and incentive model
    What are potential strategic risks and challenges to be anticipated with the deployment of the blockchain system?
    Has the blockchain’s (use case) value proposition been clearly communicated to participants? (e.g., secure transactions, operational savings, revenue, or other benefits)
    Is the network’s incentive model structured correctly to attract the desired participants or to get participants to commit the desired level of resources?
    Is there a risk of participants not willing to share sensitive information or to accept rules that may be counter to their individual interests?
    Brand and reputational risks
    Could there be lawsuits from breach of contract, compromise of data, or other incidents if stakeholder expectations aren’t met?
    Who is responsible for external communications in the consortium? How will credit be attributed for accomplishments of joint efforts within the consortium?

    Change management risks
    Have change management plans been formulated while accounting for potential future scenarios arising from blockchain-based business models?
    Is there clarity on workforce, talent, and role changes needed to make the blockchain-based business model effective?
    Are there appropriate measures in place to account for cultural changes within the consortium (e.g., shared accountability)? Is there a plan in place to communicate changes to the stakeholders within and outside the consortium legal entity?
    Has an exit strategy been defined for consortium participants who may wish to leave?

  • AuditNet

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