Great known unknown – ESMA report on Distributed Ledger Technology sets out view on Blockchain

by Marco Iezzi and Stefan Heine. 

Since as early as on February 7, 2017 ESMA issued its report “The Distributed Ledger Technology (DLT) Applied to Securities Markets”. The report sets out ESMA’s view on DLT, its possible applications, benefits, risks and how it maps to existing EU regulations. The report reflects the feedback from the market respectively the responses to ESMA’s discussion paper published in June 2016 which was based on their April 2015 call for evidence on investments using virtual currencies or DLT. The discussion paper was addressed to a broad range of market participants, and more than 50 answers have reached ESMA at the end of the consultation period. Aside from the banking industry, it was mainly market infrastructures, such as regulated markets, exchanges and trading systems, clearing houses, and central securities depositories, as well as the fintech industry who took the opportunity to play a part in shaping the regulatory opinion regarding the Distributed Ledger Technology. Building on the responses to the discussion paper, ESMA drew up a clear and well-structured report that addresses the key benefits and risks of DLT applied to securities markets, and gives an answer to the question if and how DLT would map to the existing European regulatory regime.

What is a distributed ledger?

The Distributed Ledger Technology – sometimes better known as ‘Blockchain’ – seems to be the great unknown for most people, even if the Buzzwords ‘Blockchain’ or ‘Bitcoin’ appear almost every day in the news, and almost every major financial institution in the world is doing blockchain research right now. A 2016 survey of the German statistic portal asked the question “Do you know the term ‘Blockchain’?”. 81 percent answered with “No” which means that only 19 percent knew the term. But knowing a term doesn’t mean knowing its meaning. Therefore, it is hardly surprising that only 5 percent stated that they were already familiar with this technology, or have even used it. Before taking a closer look at the ESMA report and its key learnings, a short answer to the question “what is a distributed ledger?” should be provided.

Distributed ledgers are essentially records of electronic transactions, like accounting ledgers, that allow their users to store and access information relating to a given set of assets and their asset holders in a ‘distributed’ or shared database. The uniqueness of this system lies in the fact that it is collectively maintained by all participants, the so-called ‘nodes’, rather than by a central party, meaning that there is no central validation system, like a bank or a clearing house. Essentially, the nodes are the computers of each individual participant, building together the distributed network, where each node contains a complete set of the transaction records. Another feature of distributed ledgers is the use of public-key cryptography and hash functions to store and validate transactions, and to safeguard the details of ownership. Whenever a transaction takes place, the relevant information is exchanged and cryptographically signed between nodes and added as a bijective and irreversible ‘block’ to the preceding block. That explains the origin of the word ‘Blockchain’. Moreover, in terms of users’ participation, distributed ledgers can be divided into unrestricted versus restricted or permissioned systems. An example for an unrestricted system is the blockchain of the cryptocurrency Bitcoin where anyone can contribute to the validation process. Restricted or permissioned systems, whose updates can only be proposed and validated by authorized participants, are likely to be used in financial and securities markets.

Core findings of the ESMA report

ESMA believes that DLT could bring several benefits to securities markets, especially when clearing and settlement becomes more efficient and almost instantaneous, as trade confirmation, affirmation, allocation and settlement is combined into one single step. Even if DLT was not originally designed for reporting purposes, and it may therefore be more complex than anticipated to use it for reporting, ESMA believes that DLT could enhance reporting and supervision functions at firms and regulators. The distributed and shared nature of the system might have advantages compared to current systems when it comes to a cyber-attack or a system breakdown, which could reduce the need for costly recovery plans, remarkably. Moreover, DLT could lead to shorter settlement cycles and an acceleration of collateral movements, which in turn could lead to more collateral being available in the market.

When turning to the challenges and constraints of DLT, ESMA notably highlights the management of potential privacy issues, as well as regulatory and legal issues, as important considerations to be made. Especially as it is likely that DLT will be deployed gradually across the securities markets and therefore several DLT networks will co-exist, the need of interoperation with each other and with legacy systems will be mandatory for those networks. In addition, ESMA addresses that scalability could be an issue, most of all for unrestricted systems. Therefore, solutions must be developed to consider additional functionalities, such as netting, if DLT should truly aim at replacing the current systems in use within the derivatives post-trade industry.

Considering that the level and scope of the risks of DLT will vary depending on the type of activity and application, ESMA addresses that the security of private keys remains paramount, even if DLT has several interesting features from a cyber security perspective and the ‘cracking’ of the encryption algorithms is deemed to be unlikely today. In addition, ESMA points out that, even if DLT could help mitigating operational risks, due to a greater standardization and automation of post-trade services, the network character of DLT might enable the dissemination of errors with an adverse effect to a greater number of participants.

Finally, ESMA sets out its analysis of how DLT would map to the existing EU regulatory framework depending on its applications to securities markets, considering that DLT is likely to be used primarily for post-trading activities, such as clearing, settlement and securities servicing. Therefore, ESMA focusses in the first stage on the main EU legislations on post-trading, namely EMIR, CSDR, MiFID II, MiFIR or SFTR, considering that DLT is still at an early stage and is subject to ongoing developments. A more detailed analysis of the interaction between the existing EU regulatory framework on post-trading and the application of DLT to securities markets will be represented in a further article on Blockchain.

Is Europe going to be outpaced?

Hence the possible benefits, risks, and legal frameworks of DLT are analyzed and discussed in Europe in detail, the technology and its pioneers are preparing to outpace the sceptics and procrastinators. The blockchain technology and its applications to securities markets proceed rapidly, especially in Asia and the US, and it’s no longer the fintechs alone overseeing the further development of the technology and its possible applications. An increasing amount of established market participants and market infrastructures collaborate with start-ups and fintechs on leveraging DLT to build new applications to their core business, and to keep the speed of innovation up. When looking at DLT, you can see the typical pattern of technical innovation, where there is a good case to believe that DLT has already peaked the inflated expectations, as described by the ‘Hype Cycle’ of the American IT research and advisory firm Gartner. And when you look at all the efforts made by an enormous number of companies, and how mainstream adoption of the DLT starts to take off, there seems to be the ‘Plateau of Productivity’ already looming at the horizon.

In January 2017, DTCC, one of the premier post-trade market infrastructures for the global financial services industry, announced that it’s going to develop a DLT solution for the firms’ derivatives platform that currently automates the post-trade processing for approximately $11 trillion of cleared and bilateral credit derivatives, in collaboration with IBM, Axioni, and R3. With the DLT promoted by regulators, for example in the UK and the US, there is a good case to believe that it will deliver its promise of the benefits for the financial markets.

This article was first published on Thomson Reuters Regulatory Intelligence on 18th April 2017.

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