Blockchain and distributed ledger technology – the future of financial services?

This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.

Summary

On Thursday, 2 June 2016, the European Securities and Markets Authority ("ESMA") published a discussion paper seeking responses on the use of distributed ledger technology ("DLT") in financial securities markets. The paper sets out ESMA's analysis of the potential risks and benefits of using DLT in securities markets, how it envisages DLT will initially be used in securities markets, current challenges to such use, and how such use might interact with the existing regulatory framework. With significant record keeping and reporting requirements on the way as a result of MiFID II, as well as new transparency rules in the Market Abuse Regulation, many firms will be worried about how to ensure that transactions are accurately time and date stamped, and in the correct chronological order. DLTs and blockchain may provide the technology for them to be able to do so.

What is DLT?

DLT is a shared database used to effect transactions between parties. In practice the shared database is brought about by a number of separate servers, placed in different locations. It is updated and validated by users in the network, without the need for a central database management system, normally by way of network consensus – meaning that transactions which are agreed and validated by a majority of the servers are accepted as 'true'. The shared database could be public or private, with each recorded transaction validated when a specified proportion of the DLT network's users have reached consensus as to its legitimacy.

How could DLT affect your business?

In the last couple of weeks Santander announced it is trialling a money transfer app (in partnership with Ripple Labs, Inc.) which uses DLT to clear transactions – this is a significant move by a high street bank into this new technology. Santander is boasting that even international transfers made on its app will clear and become available within 24 hours of being executed. DLT will also be of interest to firms engaged in securities markets, as it could be used instead of traditional settlement technologies, which typically involve a lack of integration between counterparties. In wider applications, DLTs could be used by parties in their contractual arrangements, both to evidence ownership and also to bring about the actual transfer of property or information.

Blockchain and beyond

The Blockchain network, one of the most renowned DLT systems, is entirely public, unrestricted, but also anonymous (users participate via the use of pseudonyms) and any transaction executed on it (even unlawful) is irreversible once it is validated. However, DLT used in financial markets would need to be structured differently, allowing for full disclosure of identities and transactions. As ESMA suggests, DLT in securities markets would need to be restricted, and allow for the implementation of KYC, transparency and accountability via regulators, respect for the rule of law, and confidentiality of trading strategies. While ledgers could be public or private, updates to the ledgers may only be proposed or validated by authorised participants. It is likely that certain elements of the Blockchain network would be seen as suitable for DLT used in securities markets, in particular the employment of cryptography to validate transactions.

Risks and Benefits of DLT

ESMA envisages that if DLT is employed in securities markets, it will initially be used mainly to as a record of ownership, and to carry out certain post-trade processes such as clearing, settlement and securities servicing. However, with each benefit provided by DLT comes corresponding risks, some of which are set out in the table.

Regulatory approach for distributed ledger technologies

In its paper, ESMA sets out the key requirements it thought would be likely to apply to entities willing to use DLT, depending on the type of securities involved and any related activities, in particular for the post-trade activities of clearing, settlement and securities servicing:

• Clearing: DLT networks set up to clear over-the-counter ("OTC") derivative transactions would need to comply with the relevant obligations under the European Market Infrastructure Regulation ("EMIR") and the Markets in Financial Instruments Regulation ("MiFIR"). These require certain OTC derivatives to be cleared by authorised central counterparties ("CCPs"), and other OTC derivatives to be voluntarily cleared by the CCPs, or be subject to risk mitigation techniques to measure, monitor and mitigate operational and counterparty credit risk. Where relevant, any DLT network would therefore have to negotiate an agreement with an existing CCP, set up a new legal entity which would apply for CCP authorisation, and/or implement suitable risk mitigation techniques depending on the OTC derivative being traded.
• Settlement: Depending on whether a DLT is designated as a securities settlement system, it may need to comply with the Central Securities Depositories Regulation ("CSDR") and/or the Settlement Finality Directive ("SFD"). The CSDR harmonises securities settlements systems across the EU, and the SFD seeks to reduce systemic risks associated with participation in payment and securities systems, especially those related to the insolvency of a participant in the system. These rules contain reporting and other requirements which will apply to a DLT depending on its designation under the relevant legislation.
• Safekeeping and record-keeping of ownership of securities and rights attached to securities (including securities asset servicing: There is no harmonisation of safekeeping and record-keeping of ownership of securities generally at EU level. A DLT will need to be assessed under national laws and any other EU law regimes which may interact with them to determine what rules apply. These will determine what records issuers of securities might need to keep, and what records of ownership investors must keep (e.g. the requirement for depositaries for the safe-keeping of assets under the Alternative Investment Fund Managers Directive).

Conclusion

Blockchain and related DLT technologies have been hailed as the next big change in financial services for a number of years now and ESMA's analysis and call for responses marks a key step in bringing them closer towards mainstream application. However readers must note that ESMA's paper is a preliminary analysis which does not set out a finalised stance on the treatment of DLTs.

As part of the discussion paper ESMA is seeking stakeholder views on the use of DLT in securities markets, in light of its popularity and potential for securities markets. Interested participants should send their responses to ESMA by 2 September 2016.

A link to ESMA's discussion paper is available here: https://www.esma.europa.eu/press-news/consultations/consultation-distributed-ledger-technology-applied-securities-markets