by Marco Iezzi and Stefan Heine.
As discussed in our Article “The great known unknown – Report on Distributed Ledger Technology (DLT) sets out ESMA’s view on Blockchain”, dated April 25, 2017, ESMA issued their February 7, 2017 report “The Distributed Ledger Technology (DLT) Applied to Securities Markets” 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.
Where the compliance of the DLT with regulatory requirements remains an almost unexplored blank spot on the map, and in which regard regulators have published only few regulatory principles that qualify as a guidance for market participants, ESMA’s report is one of the few exceptions where a regulatory authority to some extent sets out an 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, and that the decentralized and cross-border nature of most DLT platforms leads to the questions how and by whom such post-trading activities should be regulated. Although it remains unclear whether the key risks and legal issues associated with DLT can be moderately and effectively dealt with using the existing regulatory provisions, ESMA points out ‘that the current EU regulatory framework does not represent an obstacle to the emergence of DLT in the short term’. Nevertheless, ‘ESMA’s purpose in this report is not to make any recommendations on possible ways to address the regulatory challenges that DLT could raise at this stage’.
In the following, we will focus on two of the major topics of the Pittsburgh 2009 G20 decisions on OTC derivatives and their implementations, namely the provisions regarding the clearing of OTC derivatives through central counterparties, laid down in EMIR and MiFIR, as well as several legislations such as MiFID, EMIR and SFTR, introducing reporting obligations across derivatives und securities markets.
As it is ESMA’s intention not to make any recommendations nor to reveal possible applications of DLT to post-trading activities, ESMA chooses in their analysis a strictly technical approach that tries to map the existing regulatory framework to the usage of DLT in current markets and market infrastructures. Even though the implementation of DLT to the clearing of spot transactions seems the more likely near term scenario for many of the market participants, ESMA straightens out that those spot transactions are not in scope of the clearing obligations under EMIR and MiFIR meaning that ‘any initiatives seeking to combine the clearing (…) would not be affected by these regulations’. Notwithstanding it must be remembered, that CCPs once they are authorised or recognised from ESMA are subject to the EMIR requirements and to the supervision of the European Authorities for all their activity, i.e. for all the products cleared including spot transactions, if provided.
With respect to OTC derivative transactions, it is important to recall that all those transactions are subject to the EMIR requirements in a certain way. On the one hand, standardized OTC derivative transactions are subject to the clearing obligation. For those type of transactions, ESMA points out that ‘if market participants were to set up a DLT network to clear these transactions, the DLT network would need to comply with requirements set by EMIR’, and that such a DLT network ‘would need to meet the definition of a CCP under EMIR and obtain a CCP authorization or an existing CCP would need to join the network’. Considering that building a “DLT-CCP” from the scratch might be kind of rocket science for new market participants, and, among others, with a London-based working group created by the London Stock Exchange (LSE), some worlds’ leading clearing houses such as LCH, CME, and Euroclear, as well as some major banks, already in place since late 2015 looking at how blockchain technology can transform the way securities are traded, cleared, settled and reported, it is merely a matter of time, before one CCP is joining the network using DLT for clearing activities.
On the other hand, OTC derivative transactions not cleared by a CCP are subject to a range of risk mitigation techniques set out in Article 13 of EMIR and laid down in the ‘Regulatory technical standards for risk-mitigation techniques for OTC derivative contracts not cleared by a central counterparty’ (Commission Delegated Regulation (EU) 2016/2251). ESMA points out that those standards do ‘not prescribe the type of technology to be used for these mitigation techniques’. One of the key requirements arising from the risk-mitigation RTS is the obligation of the bilateral exchange of margin, which is one major topic on discussions where to use DLT in post-trading services most reasonable.
As well as for the margin calls in relation to cleared transactions, it is the usage of so-called ‘Smart contracts’ that could be applied for automatic transactions, such as issuing and reacting to margin calls, or optimizing the use of collateral, to take place in the shared ledger in response to a trigger event. A smart contract can be described as a code that is uploaded to the ledger, rather than basic passive data entries. They are programmed to generate instructions for downstream processes if the trigger event has been met. Like passive data, they become immutable once accepted onto the ledger. Keeping this functionality in mind, ESMA however considers that the use of smart contracts to automate margin calls and payments during derivatives transactions has potential to cause a systemic event. ESMA literally points out that ‘smart contracts in particular, because of their embedded automated triggers, might exacerbate one-directional market reaction in times of stress. DLT could also increase interconnectedness between market participants’.
With several legislations such as MiFID, EMIR and SFTR being effective, introducing a myriad of reporting obligations across derivatives und securities markets, market participants as well as regulatory authorities are exposed to various challenges. For example, under EMIR the details of any derivative transaction must be reported to a trade repository no later than the working day following the trade date, which is quite often rather complex and complicated, due to data quality and a permanent need of data reconciliation for both, the trading parties and the trade repositories. With new regulations like MiFIR and SFTR in place, the scope and the volume of transactions to be reported on a daily basis will increase dramatically, again. Moreover, with similar but different reporting requirements in other jurisdictions in place, such as the Dodd-Frank Act in the US, trade parties must report tremendous quantities of data to different regulators, while reporting is not consistent between the different regulations.
With DLT used for regulatory reporting, the reporting could take place automatically and in near-real time, meaning that the transaction data will be readily available to the trade repositories and regulators in an unified form, with the distributed ledger representing the so-called “Single source of truth” (SSOT). As a result, when all transactions data and information are directly and electronically available, regulators could keep track of each transactions and of outstanding positions, with the result that the much-cited “interoperability” between market participants could be achieved. Nevertheless, one must take into consideration that, even with a “DLT regulatory reporting” in place, there are currently different reporting requirements in different jurisdictions that must be harmonized, before the benefits from the DLT will pay off.
In addition, ESMA points out that there is a wide set of rules provided by EMIR and SFTR, such as provisions on record-keeping and data-management requirements, that must be considered, especially by the trade repositories. Considering the benefits that could arise from DLT used for regulatory reporting, ESMA realizes, ‘that some changes to the existing regulatory requirements may be needed, e.g., if DLT is widely deployed across securities markets and regulators have a direct access to the information stored on DLT. This scenario seems relatively remote for the time being’, from ESMA’s standpoint.
It can generally be regarded as positive that the competent supervisory authorities, such as ESMA, ECB, or the Hong Kong Monetary Authority (HKMA), to name just a few, are already dealing with the use of DLT in post-trading services at an early stage. It should be noted that they thereby asses the new technology not only from a pure risk-based standpoint, but also consider the possible benefits of using DLT, especially in post-trading services. Notwithstanding, ESMA also outlines the problem areas in the mapping of the applicable regulations to the specifics that a usage of DLT entails. It will be exciting to see how financial markets regulation will change regarding to an increasing market readiness of DLT, or to express it in the words of ESMA, if ‘on the one hand, some regulatory requirements could become less relevant, while, on the other hand, additional requirements may be needed to mitigate emerging risks.’
A version of this article was first published on Thomson Reuters Regulatory Intelligence on 8th May, 2017.