ESMA is consulting on the application in securities markets of distributed ledger technology (DLT) – commonly called ‘Blockchain’ in the area of virtual currencies. ESMA is seeking feedback from FinTech companies, banks, central counterparties, central securities depositaries, custodians, asset managers, investment funds. The purpose of the consultation is to identify the benefits, risks and challenges of the application of DLT within the securities markets and ways of addressing the risks. It comments on the existing regulatory framework but makes no presumptions at this stage about the need for new rules.
There has been a spate of press coverage about ‘Blockchain’ and that it could lead to a step-change in the evolution of financial markets. Regulators are now asking questions about safety and soundness around the wider use of DLT.
Distributed ledgers are essentially records of electronic transactions, maintained by a shared or “distributed” network of participants and not by a centralized entity. DLT has been used for virtual currencies for some time, and is commonly known in that sphere as Blockchain, which was designed specifically for Bitcoin. ESMA understands that DLT used in the securities markets would differ in a number of ways. In particular, Blockchain is an open system in which all can contribute to the validation process (a “permission-less” system), whereas use of DLT in securities markets is more likely to be permissions-based systems with only authorized participants. This has potential implications for the assessment of benefits and risks.
ESMA identifies possible benefits of DLT in clearing and settlement, record of ownership and safekeeping of assets (including shares/units of funds), reporting and oversight, reduction of counterparty risk, efficient collateral management, continuous availability, security and resilience, and cost reduction. DLT might also be used to enhance pre-trade information and the matching of buyers and sellers.
However, there are challenges and possible shortcomings in its use. Technologically, these include scalability issues, interoperability with existing market infrastructure, the need to settle in central bank money, a recourse mechanism, gross positions (as opposed to netting), margin finance (which currently allows participants to transact with assets financed externally) and short selling of securities. Also, there are governance, privacy, regulatory and legal issues. In particular, the capacity of DLT to fit into the existing regulatory framework may limit its deployment (ESMA mentions over 10 different pieces of EU legislation), and the legality and enforceability of the records needs careful consideration.
Key risks are identified by ESMA as cyber, fraud, money laundering, operational, herding behavior (hence, increased market volatility) and (un)fair competition.
The deadline for responses to ESMA is 2 September. Responses will inform ESMA’s development of its position on the use of DLT in securities markets and its assessment of whether a regulatory response may be needed. No time frame is given for this.