On April 10 2017 the UK Financial Conduct Authority (FCA) published a discussion paper (DP17/3) to gauge market participants' views on how the future development of distributed ledger technology (DLT) should be regulated by the FCA in FCA-regulated markets.
What is DLT?
The FCA discussion paper describes DLT as:
"a set of technological solutions that enables a single, sequenced, standardised and cryptographically-secured record of activity to be safely distributed to, and acted upon by, a network of varied participants. This record could contain for example, transactions, asset holdings or identity data."
There is therefore no need for a central trusted authority or intermediaries and the technology is 'immutable', so records cannot be amended except through agreed protocols by the participants (or a subset of the participants) with this being known as the consensus protocol.
The record itself is either private or public (ie, available to be viewed only by certain parties or by anyone) and either permissioned or unpermissioned (ie, where only participants with specific rights can add or change the record or where anyone can make such additions or changes). A permissioned system of DLT with only authorised participants is most likely to be used in financial markets.
A commonly known form of DLT is blockchain. In simple terms, 'blockchain' is a technology that enables a shared ledger to be maintained by multiple parties and updated simultaneously. The ledger stored on the blockchain is shared among a distributed network of computers. New transactions are entered in blocks into the shared ledger once validated in accordance with the consensus protocol – without the need for a central authority – and are protected by encryption. These entries generate a time-stamped record of history and audit trail, with the possibility of automatic identity verification.
Why is DLT important to derivatives transactions?
Cost savings Applying DLT to derivatives transactions could result in huge benefits, including:
- large-scale savings on back-office functions;
- greater certainty;
- reduction in counterparty risk;
- faster execution and verification of information;
- reduction in duplicative record keeping; and
- compliance benefits.
Given its potential to create significant efficiencies in the derivatives markets, DLT has generated attention around the globe as market participants collaborate or explore their own initiatives.
Smart contracts Another application of this technology in the derivatives market would be the use of 'smart contracts', which are computer programs that allow agreements to be executed when certain conditions are met. For example, a smart contract could be created to execute a straightforward option between two contracting parties and could then deal with the ongoing payments or the margin requirements. However, while a smart contract could conceivably be created on the basis that the industry standard documentation is incorporated by reference, the parties would need to agree on what would happen where an event occurred which required a degree of analysis or discretion. It is also not clear how disputes would be resolved or who would be responsible for the coding. It is also not certain whether the technology could facilitate close-out netting. However, given the benefits, the FCA is of the view that there will no doubt be situations where smart contracts may be a useful option.
Central clearing The European Market Infrastructure Regulation (EMIR) requires certain standardised over-the-counter derivatives contracts to be cleared through a central counterparty (CCP). If market participants were to set up a DLT network to clear these transactions, the DLT network would need to comply with the EMIR requirements. However, the European Securities and Markets Authority (ESMA) is of the view that the clearing of some spot transactions with DLT as the underlying seems the more likely near-term scenario. Spot transactions fall outside the scope of the clearing obligation under EMIR.
In the longer term, the development of DLT might see the disintermediation of CCPs if it could facilitate the immediate execution and settlement of transactions (although this is currently not viewed as a priority by many market participants). It would then be acting as the definitive record of title to the traded derivatives. However, the removal of CCPs could introduce new systemic risk and is likely to require amendments to EMIR.
Regulatory reporting EMIR, the Securities Financing Transactions Regulation and the EU Markets in Financial Instruments Directive (MiFID II) impose significant requirements on derivatives counterparties to reconcile their trades, keep records and report trades to trade repositories, which require huge back-office costs. DLT could significantly ease derivatives counterparties' burdens in reconciling and reporting trades as there would just be one record on the DLT, which the regulator could also be given access to, so there would be no need to report trades to a trade repository, for example. This would clearly require amendments to these regulations.
The use of DLT could obviate the need for trade confirmations, given that all participants to the DLT should see the details of the trade immediately. The requirement to produce trade confirmations under EMIR may then need to be amended.
Discussion paper overview
While the FCA is committed to fostering innovation that advances its objectives, it also recognises that as a regulator it needs to strike a balance between supporting innovation and ensuring customers are adequately protected. The FCA sees DLT as an example of rapidly developing technology which offers exciting potential to support the needs of consumers and the market, although it may present new challenges and risks.
The FCA sees that the benefits are likely to emerge in sectors where multiple participants need to share data and/or processes safely, especially where firms are still reliant on paper-based records.
Although the FCA generally takes a 'technology neutral' approach to regulating financial services, it is considering whether there is anything distinctive about DLT which would require a different approach as there may be regulatory barriers to the development of DLT which are currently unknown. DLT's potential and processing speed suggest that aspects of existing rules may need to be reviewed.
The discussion paper states that there may be specific areas where DLT does not fit within its regulatory requirements but still achieves its desired outcomes, and the FCA will consider whether any rules prevent or restrict sensible development that would benefit consumers. However, the FCA does not see a clear need at this stage to consider changes to its regulatory framework for DLT solutions to be implemented. Instead, the FCA is keen to explore emerging business models and the discussion paper therefore invites responses on the risk and opportunities that DLT presents as well as thoughts as to whether any of DLT's characteristics make it challenging to fit within the existing regulatory framework.
The FCA recognises that there are certain legal questions that are beyond the remit of the discussion paper, such as the conflict of laws issues regarding contracts executed on a DLT platform across multiple jurisdictions simultaneously, which would be a matter for the courts to decide and changes to primary and secondary legislation, which would require the involvement of Her Majesty's Treasury.
Given the cross-border applications of DLT, the FCA recognises that regulatory collaboration is important to ensure that disproportionate barriers to innovation can be identified and is actively working with other regulators, including ESMA and the International Organisation of Securities Commissions.
The FCA acknowledges that although there have been many successful proofs of concept, DLT may face challenges before widespread use as it will need to interact with non-DLT legacy systems, so the likely breadth and depth of market adoption of DLT is still uncertain.
In order to stimulate this discussion, the FCA has asked market participants to respond to a series of questions which are set out in the discussion paper.
Regulators across the globe have been monitoring the development of DLT and many have published reports which strike a similar tone on their current approach of monitoring developments. The shared view is that any changes and related efficiency gains are likely to be incremental rather than revolutionary.
ESMA In its recent report dated February 7 2017 ESMA stated that it has adopted a 'wait and see' approach towards DLT so it can monitor developments rather than regulate activity that could hamper the growth of the technology. ESMA believes that the technology could bring a number of benefits, including more efficient trade processes, enhanced reporting and supervisory functions, greater security and availability, reduced counterparty risk, enhanced collateral management and reduced costs.
However, the report accepted that these benefits are conditional on a number of challenges being met, including that if DLT deployment is gradual, then DLT systems will need to coexist with legacy systems and it will need to facilitate delivery versus payment and netting if it is to be widely adopted. Users would need to establish an appropriate governance framework and other risks such as cyber and operational risks would need to be carefully managed. ESMA also believes that, under certain market circumstances, DLT may contribute to increase market volatility, because of the embedded automated triggers, although this would be relatively low in the short term but could increase as the technology develops.
ESMA is of the view that DLT is most likely to be used for post-trading activities such as clearing and settlement and considers that the current EU regulatory framework does not represent an obstacle to the emergence of DLT in the short term, although some requirements may become less relevant over time while new rules may be needed.
BIS In its recent report on distributed ledger technology published on February 27 2017 the Bank of International Settlements (BIS) stated that DLT has promise but that there is still a long way to go before that promise may be fully realised. The BIS warned that DLT may pose new or different risks, including potential uncertainty about operational and security issues arising from the technology and the absence of an effective legal and governance framework. It stressed that much work is needed to ensure that the legal underpinnings of DLT arrangements are sound, governance structures are robust, technology solutions meet industry needs and that appropriate data controls are in place and satisfy regulatory requirements.
FINRA In its recent report on DLT in the securities industry issued on January 18 2017 the Financial Industry Regulatory Authority (FINRA) provided a detailed look at DLT and requested comments on how DLT would interact with the securities industry. The report recognised that there are some great potential synergies in DLT and the securities industry, especially in clearing and settlement, but that DLT activity in the highly regulated US financial sector requires further review and research. The report went into considerable depth on the potential applications of DLT to the securities industry, including applications in the equity, debt and derivatives markets, as well as for use cases involving industry utilities such as product reference data and customer identity management.
The report also considered the potential impact of DLT on the securities industry, such as reducing market inefficiencies, improving transparency, clarifying roles of intermediaries and addressing operational risk. In addition, FINRA also identified factors in the report that it believes should be considered when implementing DLT-based solutions, including governance, operational structure and network security. FINRA concluded its report with a consideration of a variety of regulatory issues in the United States which are relevant to the adoption of DLT solutions in the context of the capital markets, including the handling of customer funds and securities, broker-dealer net capital rules, anti-money laundering requirements, books and records maintenance requirements and customer data privacy.
As industry efforts to use DLT continue, the FCA expects that in the second half of 2017 and into 2018 there will be more movement from the 'proof of concept' stage to 'real-world' deployments. There is no doubt that regulators globally will continue to monitor these developments. For its part, the FCA is interested in exploring where the balance of risk and opportunities may lie relative to DLT, and will accept comments on the discussion paper until July 17 2017. Following this comment period, the FCA will issue either a summary of responses or a consultation paper.
For further information on this topic please contact James Doyle or Isobel Wright at Hogan Lovells International LLP by telephone (+44 20 7296 2000) or email (email@example.com or firstname.lastname@example.org). The Hogan Lovells International LLP website can be accessed at www.hoganlovells.com.
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