Institutional interest in distributed ledger technology (DLT) — particularly in the realm of financial market infrastructures (FMIs) — continues to deepen. International regulators continue to successfully trial various use cases and are also in the final stages of launching sandbox initiatives. Market participants should consider taking advantage of these opportunities in order to reap the benefits of potential front-to-back innovation in trading and post-trading processes.
DLT comes in two forms — permissionless or permissioned — based on the level of decentralisation. Our previous update described how, for mainstream institutions, the future likely lies in the latter. In the case of FMI players specifically, research by the IMF confirms that only permissioned networks are suitable.
Within this context, FMIs across developed and developing markets, and along various parts of the value chain, have been actively investigating DLT opportunities for many years. The technology demonstrates potential for financial infrastructures to move toward real-time settlement, continuous operations, improved resilience and global reach. It could also fundamentally change the role of intermediaries operating within the securities trading, clearing and settlement cycle, particularly if activities currently performed by separate FMIs can all be performed on the same ledger.
In order to experiment with harnessing these benefits in a safe and secure way, regulators in several jurisdictions are preparing to launch pilot projects and sandbox initiatives.
In this respect, the EU has been a first mover. Final regulation has been agreed for the pilot regime for market infrastructures based on DLT (which ESMA has now dubbed DLTR) — which sets out a legal framework for the trading and settlement of transactions in crypto-assets that qualify as financial instruments (under MiFID II). Similar to a sandbox approach, the pilot allows for `safe experimentation' and will provide evidence for a potential subsequent permanent regime.
Under the pilot:
- Authorised financial institutions (including investment firms, market operators, central securities depositaries (CSDs)) will still require specific permission to participate. Access will not be limited to incumbent institutions but will also be open to new entrants
- Permission is limited to a period of up to six years and will be periodically reviewed
- Permission will be valid throughout the EU
- Participating operators will be subject to various organisational requirements (robust IT and cyber arrangements, sufficient safeguarding arrangements, record-keeping obligations, investor protection arrangements, KYC/AML requirements, etc)
- Competent authorities may decide to require additional prudential safeguards from an individual operator
- There are limitations on the financial instruments that can be admitted. Only less-liquid bonds, share and fund units can participate and the aggregate market capitalisation or value cannot exceed €6Bn at the moment of admission to trading (or initial recording) of a new DLT instrument
Once permission to operate in the pilot has been granted, DLT operators will then be able to request exemptions from current regulations including:
- Intermediation — direct access for natural persons to deal on own account as DLT infrastructure participants is possible
- Transaction reporting (under MiFIR)
- Recording and settling DLT financial instruments with a CSD — operators will be allowed to combine the activities normally performed by both Multilateral Trading Facilities (MTFs) and CSDs
- Settlement discipline requirements
- CSDR settlement finality requirements
- Rules on cash settlement — however, delivery versus payment (DvP) still has to be ensured
Various actions now lie with ESMA. The securities regulator is currently consulting on draft guidelines to establish standard formats and templates for the submission of the required information by market participants to the competent authorities. It is looking to finalise this ahead of March 2023, when the DLTR provisions go live.
ESMA is also required to assess MiFIR regulatory technical standards (RTSs) on trade and transaction reporting to see whether they need adapting to be effectively applied to DLT financial instruments.
And finally, ESMA has been tasked with creating a report (by March 2026) on the success of the pilot and any recommended next steps.
The UK is set to follow the EU's lead, although with a slightly slower timeline.
The responses received to HM Treasury's (HMT) 2021 Call for Evidence identified the need for a re-evaluation of the legislative framework to enable a successful application of DLT to FMIs. As such, in July, HMT introduced, via the new Financial Services and Markets Bill, the ability to establish FMI regulatory sandboxes.
Within these sandboxes, HMT will be able to temporarily disapply or modify relevant legislation, to allow participating FMIs to “test and adopt new technologies and practices”. This aligns with the EU's DLTR and is a step away from the FCA's original regulatory sandbox (launched in 2016). However, unlike the EU equivalent, the scope of these UK sandboxes is intentionally not limited to DLT, in order to maintain technology neutrality.
HMT intends to consult industry on the proposed list of legislation in scope for modification and retains the ability to amend this list in the future. HMT will also be able to make permanent changes to legislation (via statutory instrument subject to the affirmative procedure) based on what is learned in each sandbox, having first reported back to Parliament.
An FMI sandbox will be created by a statutory instrument, and a full impact assessment will be provided as and when that occurs. Each statutory instrument will set out:
- The relevant legislation to be modified or disapplied
- The activities that FMIs are permitted to undertake
- Requirements and restrictions for participants (e.g. the types of securities to be traded and settled)
- The role and enforcement powers of the regulators
- The duration of the sandbox
- The processes for winding down or transitioning activities at the end of a sandbox
Examples of potential FMI entities include existing recognised CSDs and operators of MTFs, though the scope could be extended to include other categories in the future. These entities will be required to apply to the regulators in order to participate in the sandbox, and only a limited number will be selected.
Despite policy work already being underway, the sandboxes will not formally launch until early 2023 (following formal assent of the Bill).
Further afield, wider DLT experimentation continues to progress.
In September 2021, SIX Digital Exchange (SDX) in Switzerland received regulatory approval from FINMA to operate SDX, an end-to-end, fully regulated exchange and CSD for the listing, trading, settlement and custody of digital assets. It aims to allow financial institutions to trade digitised shares, bonds and other assets on DLT. Their first bond was issued in November.
In January 2022, Phase II of Project Helvetia was completed. This was a multi-phase investigation by the BIS Innovation Hub, the Swiss National Bank and the financial infrastructure operator SIX, exploring how central banks could offer settlement in central bank money in a scenario involving tokenised assets based on DLT. Phase II specifically demonstrated that a wholesale CBDC can be integrated with existing core banking systems and processes of commercial and central banks.
And, the Australian Securities Exchange is currently working to replace its legacy post-trade system (CHESS) with a DLT-based system. As a result, market participants will be able to communicate with the new DLT based service via SWIFT or by hosting a DLT node. (However, it's worth noting that, due to the complexity of the process, this roll-out has been delayed several times since it was first announced in 2016).
Despite the progress of this experimentation, certain shortcomings and risks still persist, including:
- The IMF has reported that most experiments to-date are still being completed “under controlled and technology-focused environments” with no “cost-benefit analysis”. They also note that many reported DLT benefits (like parallel transaction databases secured by encryption and validators) can also be implemented by traditional payment systems
- Moreover, transitioning from complex and embedded legacy systems onto DLT infrastructure will be a delicate and complex process, involving increased effort and expense. Market participants would likely be required to complete their functions on legacy systems while simultaneously testing DLT, to avoid disrupting critical daily processes and to ensure that markets continue to operate seamlessly
- Further analysis is needed on the primary and secondary impacts of wide-spread adoption of DLT within payments, clearing and settlement arrangements. Regulators and legislators should account for the market restructuring and elimination of participants that could come as a result
- Use of DLT would also require the development of appropriate governance to ensure that responsibilities regarding data handling and cyber resilience are fully committed to by all network participants
- Interoperability (between DLT and non-DLT solutions, and between different types of DLT solutions) must be ensured, so as to avoid fragmentation of the trade-settlement process
- And finally, some versions of the technology can be extremely energy-consumptive and may not sit comfortably alongside efforts to tackle climate change and achieve net-zero
Overall, the ECB notes that the ultimate aim should be to achieve industry-wide international agreement on the approach to DLT via the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO), as this would facilitate long-term interoperability and integration between securities markets globally.
What does this mean for clients?
As applications open for these sandbox initiatives, market participants should make the most of the opportunities at hand. Having the ability to trial new DLT-based business models in an environment of suspended regulatory expectations will position them well for the ecosystem of the future. In particular, it will place them close to the action as the permanent regulatory regimes are determined.