On February 7, 2017, the European Securities and Markets Authority (“ESMA”) released a Report on Distributed Ledger Technology (“DLT”) (also known as “blockchain” technology) Applied to Securities Markets (the “Report”) that considers DLT’s effect on securities markets and fit to existing regulatory infrastructure. The Report ultimately concludes that while many of the laws and regulations currently in place can be applied to DLT, “international regulatory engagement and cooperation are paramount . . . to ensure both that the DLT does not create unintended risks and that its benefits are not hindered by undue obstacles.” Additionally, in an appendix to the Report, ESMA summarizes the comments of market participants to its June 2016 Discussion Paper. Last month, the U.S. Financial Industry Regulatory Authority (“FINRA”) similarly acknowledged the need for international coordination in its own Report on DLT (see Reed Smith’s summary here).
ESMA’s Report focuses primarily on permissioned blockchains that are restricted to authorized participants, rather than open access blockchains, such as Bitcoin’s, because currently most initiatives in the securities space involve these technologies. ESMA notes that current securities laws and regulations can more easily accommodate permissioned blockchains.
At the outset, the Report lists the benefits and challenges presented by DLT. It groups the benefits into four categories: (1) more efficient post-trade processes; (2) enhanced reporting and supervisory functions; (3) greater security and availability; and (4) reduced counterparty risk and enhanced collateral management. The net benefit of all of the above would be reduced costs for providers of financial services and their customers. Consistent with FINRA’s conclusions in its Report, ESMA explains that DLT could render clearing and settlement nearly instantaneous, wrapping confirmation, affirmation, allocation and settlement into a single step. This might reduce the need for central clearing and bilateral margining. The Report also states that DLT could completely change regulatory reporting by providing a single accurate and verifiable ledger that regulators across the globe could access.
The Report also lists several challenges for regulators and DLT market participants, which include: (1) interoperability and the use of common standards; (2) access to central bank money; (3) governance and privacy issues; and (4) scalability. ESMA notes that “DLT is still at an early stage and it remains unclear if the technology will overcome these challenges.” For example, the Report finds that DLT could facilitate market manipulation and other unfair trade practices because market participants might be able to access information recorded in DLT and front-run competitors or manipulate prices. The Report anticipates that DLT will gradually develop and be tested over time.
The latter half of the Report discusses the application of existing laws and regulations to DLT. ESMA believes that DLT will primarily be used for post-trading activities, such as clearing, settlement, and securities servicing. It acknowledges that, as DLT develops, regulators will need to promulgate new regulatory requirements but concludes that “the current EU regulatory framework does not represent an obstacle to the emergence of DLT in the short term.”
Notably, the Report explains that market participants must distinguish between OTC derivative transactions that are subject to a clearing mandate and those that are not. For transactions subject to mandatory clearing, DLT clearing platforms must meet the definition of a central clearing counterparty (“CCP”) and comply with relevant regulations under European Market Infrastructure Regulation (“EMIR”). Furthermore, market participants developing reporting infrastructure using DLT must be mindful of the regulations application to OTC derivative trade repositories. EMIR imposes operational, recordkeeping, and data management requirements on such facilities. Moreover, the Report explains that DLT presents novel jurisdictional issues because it may be difficult to determine where securities and their records are located in a DLT environment.
Both ESMA’s and FINRA’s recent reports on DLT demonstrate that market regulators across the globe are actively investigating potential applications of DLT and considering these developments in light of applicable laws and regulations. Market participants should review both reports to determine the existing regulations they must consider as they develop new use cases for DLT. ESMA noted in the Report summary that “[a]t this stage, ESMA believes that it is premature to fully appreciate the changes that the technology could bring and the regulatory response that may be needed, given that the technology is still evolving and practical applications are limited both in number and scope” and stressed the importance of coordination and engagement with regulators. Those developing DLT applications for the financial industry should consider approaching and working with regulators to ensure the best results in any ultimate regulation.
The Report is available here.