ESMA has published Discussion Paper: The Distributed Ledger Technology Applied to Securities Markets to present in a factual and objective manner the results of its preliminary analysis on the possible impacts of Distributed Ledger Technology (DLT) on securities markets.
ESMA has asked for feedback to this Discussion Paper by 2 September 2016. ESMA will use the feedback to develop a position on the use of the DLT in securities markets and in particular to assess whether a regulatory response may be needed to deal with DLT.
What does ESMA consider to be a blockchain?
Distributed ledgers - sometimes known as ‘Blockchains’ in the case of virtual currencies - are essentially records, or ledgers, of electronic transactions, very similar to accounting ledgers. Their uniqueness lies in the fact that they are maintained by a shared or ‘distributed’ network of participants (so-called ‘nodes’) and not by a centralized entity, meaning that there is no central validation system. Another important feature of distributed ledgers is the extensive use of cryptography, i.e. computer-based encryption techniques such as public/private keys and hash functions, to store assets and validate transactions.
Although traditionally associated with Bitcoins, the DLT that would be used for financial services differs from the Blockchain designed for Bitcoins in a number of ways. In particular, while the Bitcoin Blockchain is an open system where all can contribute to the validation process (the ‘permissionless’ system), the DLT that is likely to be used in financial markets would be a permissioned-based system with authorised participants only. This difference will in ESMA’s view lead to a number of consequences in terms of potential benefits and risks.
What is ESMA’s approach to DLT?
ESMA stresses that its work on the DLT is limited to the application of this technology to securities markets. Indeed, issues related to the payments aspect of virtual currencies are outside the scope of ESMA and are treated by other institutions such as the European Central Bank or the European Banking Authority. ESMA is interested in understanding both the benefits and the risks that the DLT may bring and ways to address those risks in light of the existing regulatory framework.
What is the possible regulatory impact of DLT?
ESMA has set out four possible markets for the use of DLT in the securities markets:
- The DLT is used by existing market participants/infrastructures to improve their internal processes. ESMA sees limited regulatory challenges with this approval, as long as market participants/infrastructures continue to comply with the relevant requirements, since the EU regulatory framework does not prescribe the type of technology that market participants/infrastructures have to use to perform their activities or fulfil their obligations.
- The DLT is aimed at changing/replacing the current set up of market participants and market infrastructures. ESMA believes that this could create a number of challenges with respect to the safeguards brought by recent securities markets regulations, e.g., if new risks are left unaddressed by the existing regulatory framework.
- A median situation, which would fall somewhere in-between situation a) and b)
- A status quo situation where the existing set up of the securities markets would prevail.
The possible benefits of DLT
ESMA highlighted the following potential benefits of DLT.
Clearing and settlement
The DLT could speed the clearing and settlement of certain financial transactions, by reducing the number of intermediaries involved and by making the reconciliation process faster and more efficient. This could make it easier for parties to transact with one another across countries.
Record of ownership and safekeeping of assets
The DLT could facilitate the recording of ownership of a variety of securities and the safekeeping of assets by promoting a unique reference database, as well as by reducing the possible ambiguity of contract terms and increasing the automation of the processing of corporate actions. The latter is assisted through the development of smart contracts, which are self-executing codes meant to replicate the terms of a given contract and effectively translate contractual terms (e.g., payment terms and conditions, confidentiality agreements) into computational material.
Reporting and oversight
The DLT could potentially facilitate the collection, consolidation and sharing of data for reporting, risk management and supervisory purposes, by enlarging the scope of information available from a single source and making access to this information easier and faster.
The DLT could reduce the counterparty risk of certain securities transactions. The DLT could, by shortening the settlement cycle of the transactions, means that each party would be exposed for a shorter period of time to the risk of default of the other party. It is even argued that the DLT may eliminate the counterparty risk of certain transactions and remove the need for Central Counterparty (CCP) clearing because the settlement could be almost instantaneous. However, as for derivatives transactions, obligations remain through the entire life of the contract, and so, there is the need to mitigate the counterparty risk throughout the life of the instrument. For this reason, ESMA believes that the DLT is unlikely to eliminate the counterparty risk from derivatives transactions and hence the benefits of CCP clearing for derivative instruments are likely to remain unchanged.
Efficient collateral management
As the DLT could help reduce counterparty risk for cash ‘spot’ transactions market participants may post less collateral for certain transactions. This would increase market collateral availability and allow market participants to reuse collateral more frequently.
The DLT could in theory operate on a continuous basis, where currently financial services processes are usually organised in batches.
The DLT could potentially be a very secure technology as a result of the distributed nature of the ledger, (i.e., there is no single point of attack), and the use of cryptography and consensus to secure and validate transactions. These features could help mitigate the risk of a cyber-attack.
A general reduction of costs is one of the main suggested benefits of the DLT, facilitating streamlining of functions, authority functions reducing the need for costing business continuity plans and reducing the need for multiple intermediaries in transactions.
Challenges to DLT
ESMA has highlighted the following challenges to the DLT being granted access to the securities market:
The issues identified include:
- whether a securities market DLT system is operable on a large scale
- whether the DLT could interoperate with existing market infrastructures and the attendant systems, at least in the short to medium term, and separate ledgers will need to interact with one another
- whether DLT can be developed so, with Delivery versus Payment transactions both the asset and cash ‘legs’ of the transactions are processed simultaneously
- how any possible mistakes in relation to the ledger could be handled from a technological and governance perspective
- how the DLT could apply to derivatives transactions for which position margins and collateral requirements are computed on a net basis given the possible resultant absence of netting; and (vi) whether margin finance and short selling would still be possible.
Governance and privacy issues
The issues identified include:
- to decide the rules for approving /rejecting participants on the DLT
- to decide the rules to govern the interactions between different participants
- to agree on the liabilities of participants, including in case of fraud or error, and correction mechanisms and penalties in case of infringement of the DLT rules or intellectual property
- to agree on a remuneration model between the participants of the DLT
- the public nature of the ledger, which is embedded in the technology, interacts with the need to preserve the anonymity and privacy of some of the information recorded in the ledger.
Regulatory and legal issues
The ability of the DLT to fit into the existing regulatory framework may limit its deployment. ESMA sets out in the Discussion Paper its analysis of how the DLT, when applied to securities markets, would map to the existing EU regulatory framework to draw stakeholders’ attention on the key requirements likely to apply to entities willing to use the DLT. ESMA also points out that differences in securities and company laws across the EU may also interfere with a wide deployment of the DLT in EU securities markets. For example, nodes established in different jurisdictions might be subject to different privacy, insolvency and other requirements.
ESMA also sees potential risks in using the DLT. In particular, ESMA highlighted the following issues.
Cyber risk, fraud and money laundering
Although the shared nature of the ledgers may mitigate the risk that a cyber-attack directed to a single point brings down the entire network, a flaw in the system could have wider consequences. If someone were to break into the system, he/she might have access not only to the information stored at the point of attack but to the full breadth of information recorded on the ledgers. If the technology itself (e.g., the encryption techniques) were hacked, the risk of contagion could extend beyond the single DLT network under attack, as the protocols used by different DLT networks tend to be similar. Also, in the absence of adequate controls, the DLT is at risk of money laundering and terrorist financing activities, notably because the use of public/private keys could make it easier to conceal identities and to hide the history of transactions.
A glitch or a failure in the system could have far-reaching consequences, because market participants would rely on the same system and the same processes, which would be largely automated, leaving the system unduly exposed in case of an anomaly. In other words the occurrence of errors might be lower but their impact could be higher.
Market volatility, interconnectedness and new pockets of risks
Through a unique reference system and more automated and harmonised processes across participants and asset classes, the DLT could contribute to herding behaviour and increase market volatility in times of stress.
Fair competition and orderly markets
The DLT could raise fair competition issues e.g. if the supporters of a DLT network could prevent new participants joining, or impose such conditions that it becomes economically unviable for new members to join the network. It might be also difficult to establish competitive ledgers or ensure the interoperability between ledgers, thus negatively impacting the competitive nature of securities markets. Lastly, unless adequate controls are in place, some participants to the network could also unduly exploit the information recorded on the network for their own advantage.