On 2 June 2016, the European Securities and Markets Agency (“ESMA”) published a discussion paper on the application of distributed technology (“DLT”) to securities markets. ESMA’s paper does little to shed further light on the European financial regulator’s stance on the emerging technology. Instead, it sets out an objective view of the uses, risks and challenges associated with the use of DLT and invites interested parties to respond.
DLT (also known as “blockchain”) is perhaps best known as the technology behind bitcoin, although in recent years it has captured the interest of the financial services industry based on its ability to create immutable, universalisable and secure records of asset ownership through its use of decentralised databases. Used in conjunction with auto-executing so-called “smart contracts”, commentators and investors are excited by the potential for DLT to radically disrupt established players across a range of potential applications.
ESMA suggests that the most likely use-cases for DLT in financial markets will brought about via “closed” or “permissioned” ledgers (distinct from the “open or “public” ledgers popularised by cryptocurrencies), in particular for post-trading functions. In particular, alongside general cost, security, efficiency and availability benefits, ESMA speculates that DLT has the potential to transform the following spaces:
- Clearing and settlement – by improving the speed and efficiency of certain financial transactions and reducing the role of intermediaries;
- Records of ownership – by changing the way in which asset ownership data is stored and used, including depositary / registrar, custody and notary functions; and
- Reporting and oversight –by providing immutable, “real time” data to both companies and regulators.
The discussion paper isn’t a one-sided treatise on the benefits of DLT, however. ESMA highlights the challenges of its implementation, which include scalability, interoperability both between market participants and with current infrastructure and the limited recourse mechanisms inherent in more autonomous processes. Interestingly, it suggests that DLT’s possession-based methodology may make it less well-suited to recording certain types of financial arrangements such as margin finance and short-selling.
It also touches on a range of risks which it suggests will need to be overcome in order to increase regulatory confidence, including privacy concerns, challenges associated an inherently trans-jurisdictional technology, operational risks relating to the interconnectedness of the market via DLT leading to greater risk leverage and competition concerns driven by the fear that some players will be left out in the cold by the system of “permissioned” ledgers.
The discussion paper highlights that DLT is not developing in a vacuum, and that market participants will need to take care to ensure compliance with existing securities laws such as the European Market Infrastructure Regulation (“EMIR”) and the Markets in Financial Investments Regulation (“MiFIR”) (in respect of clearance) and the Central Securities Depositories Regulation (“CSDR”) and the Settlement Finality Directive (“SFD”) (in respect of settlement), as well as national laws relating to, for instance, the recording of asset ownership. This contrasts in tone with the UK Financial Conduct Authority’s proposals for a regulatory sandbox which would allow market participants to test certain products within a more relaxed regulatory framework, which we discussed in more detail here.
The deadline for comments to be submitted to ESMA is 2 September 2016.