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“Distributed ledger technology” (DLT)[1] is creating a rapidly rising tide of discussion about its technical feasibility, now followed by debate on its potential applications to wholesale financial markets. But soon the technical novelty will collide with the harsh world of regulation. Could it turn into the technological equivalent of a “sub-prime mortgage”? Will society take that risk?
As an example, SWIFT has an interest flowing directly from its role as the secure messaging service for the world’s payments, and increasingly in settlement - epitomised by their recent article “In principle, distributed ledger technologies and smart contracts could lift levels of automation in post-trade processing to new levels by reducing the amount of information that has to be exchanged to settle a transaction, and potentially the number of parties involved as well. The realisation of these benefits depends on standardisation, and ISO 20022 provides the ideal foundation on which to build a viable transition from current to future technologies.”
As SWIFT put it, “Some argue that it hails the end of securities market infrastructures, others that there will be no revolution, just a natural evolution of what already exists….” SWIFT went on to say that its “focus is on building technical, operational and business capabilities with a view to evolving our platform such that DLT-based services could be offered to our 11,000+ members, when the technology matures and firm business use cases emerge. Such DLT-based services could be provided by SWIFT, our community or third parties.”
Coming from the global leader, this means the technology could move very fast. Moreover, the regulatory community is rapidly waking up to DLT. ESMA began analysing virtual currencies in 2013 and, in April 2015, published a call for evidence on investments using virtual currencies or the distributed ledger technology (‘DLT’). However, the results showed that investments using virtual currencies as underlying assets for products remained marginal. However, ESMA continued to keep a watchful eye on the potential benefits and risks that the DLT could bring when applied to securities markets - but from a public policy perspective, rather than technological enthusiasm.
Given the comments from such bodies as SWIFT, ESMA decided to focus on the post trading functions, which appear as the primary scope of application of the DLT rather than as a “payment” mechanism. Its Discussion Paper of June 2016 recognised that “DLT may have different applications and impacts on financial activities, market participants and market infrastructures, depending on a variety of elements, including its capacity to address a number of technical, governance, legal and regulatory issues.” More than 60 responses flooded in from a wide variety of players: fin tech, CSDs, markets, banks, asset managers, clearing houses, trade associations, etc.
So ESMA certainly succeeded in alerting players to the fact that there is already a body of securities law that will be highly relevant to developments including the European Market Infrastructure Regulation (EMIR), the Securities Finality Directive (SFD), and the Central Securities Depositories Regulation (CSDR). But Markets in Financial Instruments Directive (MiFID), UCITS Directive and Alternative Investment Fund Managers Directive (AIFMD) are also relevant for keeping records of ownership. To keep it simple, ESMA decided not to consider (at this stage) Securities Financing Transaction Regulation (SFTR), Directive on Financial Collateral Arrangements, Market Abuse Regulation, Anti-Money Laundering Directive or Short Selling Regulation.
The legal issues are likely to be substantial as there is still no harmonised definition of safekeeping and record-keeping of ownership of securities in the EU. The Giovannini Group (this author was a member) highlighted this glaring defect in our first Report in 2001. Since then, eight Working Groups have tackled some of these topics and a ninth was launched earlier this year. A Commission Consultation on a Securities Law proposal was issued in 2009 but the Member States Working Group on the subject last met in 2013. Nonetheless, Commissioner Hill gallantly proposed to solve these problems as part of his CMU strategy. As he felt obliged to resign as a result of the Brexit decision, it is not clear what momentum remains for this part of the project.
When using “permissioned” DLT in the payment aspects of securities settlement, do participants such as SWIFT effectively become a “custodial wallet provider” of a “virtual currency”? Yet another proposal is underway on money laundering and it happens to include a definition of a `virtual currency’. So the ECB was required to give a formal Opinion and it pointed out that the Treaty on the Functioning of the EU (TFEU) specifies that the euro is the single currency of the EMU, not a “virtual currency”.
Once embedded in the heart of the financial system, a failure of the technology would have catastrophic financial consequences, and the economic results might dwarf the “sub-prime” mortgage crisis. If the technology is indeed proven beyond doubt, then it may take a long time to make a controversial change to the TFEU. Thus DLT is unlikely to be a serious contender for systemically significant financial activity for a decade or more. Thereafter, a string of highly complex technical Directives would need amendment. Finally, the problems revealed by the Securities Law delays would need to be resolved.
On current form, DLT may not be in use for systemically important financial functions for a couple of decades, so well beyond the Brexiteers timetable for retaining “clearing” in the UK by applying DLT, rather than using ECB-issued euros.
[1]No idea what DLT is? Try the UK government’s handy primer – including useful definitions, especially distinguishing “permissioned” DLT: “Permissioned ledgers may have one or many owners. When a new record is added, the ledger’s integrity is checked by a limited consensus process. This is carried out by trusted actors — government departments or banks, for example — which makes maintaining a shared record much simpler that the consensus process used by un-permissioned ledgers. Permissioned block chains provide highly-verifiable data sets because the consensus process creates a digital signature, which can be seen by all parties.”
