A couple of weeks ago, I was fortunate enough to be invited to attend the FSB-CPMI's private sector meeting on distributed ledger technology (see tweets).
One of the areas covered was legal issues, where I made lead comments, along with Scott Farrell of King and Wood Mallesons' and Patrick Murck of Harvard Law. I have set out the notes I prepared for my 5 minutes below in case of interest, although please note that these are as drafted and not exactly as delivered.
This one's quite a long post, especially given I only had 5 minutes, but the TL;DR is that I covered:
- settlement and issues arising from trying to settle assets that are transferred on a distributed ledger;
- settlement finality including precisely what I mean by that term; and
- international cooperation, particularly the need to avoid different rules apply and the need to avoid a patchwork of regulation.
Notes for the FSB-CPMI meeting on DLT, 21 October 2016 (legal issues session) - Claire Harrop, Freshfields Bruckhaus Deringer LLP
Thanks and introduction.
I’m going to be a little more specific and consider securities settlement – an area that has received some attention from the Federal Reserve Bank of New York and the Bank of England, as well as others, and has been noted as ripe for innovation. From my perspective, there is a role for policy makers here. It seems like a good time to consider how the legal framework for securities settlement through the blockchain should be designed, in order to support legal certainty. This is likely to be challenging, but ultimately beneficial to all involved.
There are many issues that we could cover here but I’m going to raise two that I get asked about by clients – settlement (and the transfer of legal title) and settlement finality.
A question that we have been asked is whether it is possible, legally, to dematerialise financial instruments today and where would we be dependent on a legal and regulatory change? Would settlement of assets over a distributed ledger be legal or beneficial title? How do we get to the point of ensuring that legal title transferred?
Right now, legal ownership usually requires physically holding something (e.g., a paper bearer bond) or relying on some sort of centralised record - whether that’s the company’s share register or whether the record is kept somewhere else, like a central securities depository (CSD). Although it might seem to be the case that something as simple as settlement might be a settled topic, there are still cases in the English courts today on legal and beneficial title and the rights of investors.
In Europe, the CSD Regulation (CSDR) is pushing shares and other types of security towards dematerialisation and immobilisation in certain circumstances. But herein lies a problem – CSDR defines a CSD as “a legal person that operates a securities settlement system”. The obligations under CSDR attach to that legal person. In a world where securities settlement takes place over a distributed ledger, it becomes difficult to see who should be responsible, unless a specific legal person has been identified.
What clients are keen to understand is whether it would be possible to make legal title of securities settle by using a distributed ledger. The corollary to that is how would regulation work in a system where such a register is completely decentralised and there is no single entity that can be called responsible.
Without settlement finality, the insolvency of one participant could result in the unwinding of transactions between participants in a settlement system which would expose participants to credit and liquidity risks and therefore result in systemic disruption.
Existing settlement finality laws in Europe, with which I’m most familiar, are concerned with the finality of transfer instructions within centralised clearing and settlement infrastructure (Designated Systems). The Settlement Finality Directive (SFD) is aimed at reducing the systemic risk associated with participation in Designated Systems, and in particular the risk linked to the insolvency of the operator or a participant in such a system.
Basically, if a transfer order (that is, an instruction to transfer money or securities) is entered into a Designated System before the opening of insolvency proceedings, that order is legally enforceable. Even if the order were entered after the opening of proceedings, it would still be legally enforceable if the designated system was not and could not have been aware of the insolvency.
By disapplying insolvency law in certain circumstances, the regime protects the finality and irrevocability of transfer orders in a Designated System, and helps to ensure the enforceability of collateral provided in connection with participation in such a system. In order to be designated by a competent authority and receive these protections, systems must meet specified criteria.
Ensuring that transactions cannot be avoided because of the insolvency of the transferee may be challenging in a fully decentralised transaction settlement “system”. Again, how is it best to regulate a system that isn’t technically operated by one entity, so there isn’t a single point of responsibility.
It seems to me that settlement arrangements using the distributed ledger technology will likely require specific settlement finality rules.
The concern of clients in respect of both settlement and settlement finality is not only how it will work, but also how it will work internationally e.g., the risk of multiple blockchains with different governing laws and resultant disconnect on settlement/settlement finality when they try to operate together.
If, for example, we have banks based in the US, Japan, Indonesia all on a particular blockchain and all transferring securities (let’s say, shares in an Australian company), under what law should the securities be held? Whilst dispositions and acquisitions might not be that complicated, there may be difficulties in the arenas of arranging for security/ providing financial collateral, or where the law prescribes that there are certain time periods within which transactions can be avoided in an insolvency scenario.
The precise rules, of course, relies on certain developments being made from a technology perspective and an understanding of what is, in fact, possible. However, perhaps it is possible to discuss an approach to global regulation, even at this stage.
There is a real opportunity to avoid a patchwork of regulation in securities settlement. Without such discussion and if the law fails to come to a consistent view on settlement and settlement finality, then we may well risk not seeing as much innovation in this area.