On February 7, 2017, ESMA published a Report on the application of Distributed Ledger Technology to the securities markets. Distributed ledgers, sometimes referred to as blockchains, are essentially records or ledgers of electronic transactions that are maintained by a shared or distributed network of participants instead of a centralized entity. ESMA consulted in late 2016 on how DLT applies to securities markets. The Report provides ESMA's analysis of the key risks and benefits of DLT as applied to securities markets and how DLT maps to existing EU regulation.
ESMA is of the view that DLT could provide a number of benefits to securities markets but is also concerned that it may introduce new risks or magnify existing risks. Benefits of DLT include more efficient clearing and settlement services, enhanced reporting and supervision functions at firms and regulators for data sharing and risk management purposes, reduced costs related to the development of recovery plans in a cyber-attack or system breakdown scenario, reduced counterparty risk and enhanced collateral management. ESMA is concerned with a variety of risks, in addition to the well-documented issues of cyber security and fraud, such as the possible ramifications for market fairness and competition as well as financial instability. ESMA considers that systemic risk may, under certain circumstances, contribute to market volatility through applications such as "smart contracts" which can exacerbate one-directional market reaction in times of stress due to their embedded automated triggers. The combination of these risks could increase market complexity, operational risks and market fragmentation.
ESMA stresses that primary issues, such as interoperability and the use of common standards, access to central bank money, governance and privacy and scaleability need to be addressed first. In addition, certain legal issues also need clarification, such as legal certainty of ownership and settlement finality. ESMA notes that DLT is likely, at least initially, to be applied to post-trading activities such as clearing, settlement and securities servicing. As a consequence, securities records or principles on settlement finality will need adaptation to DLT for its implementation to increase, especially with regard to risk mitigation techniques in the context of the clearing obligation under EMIR and the Markets in Financial Instruments Regulation. Settlement activities in the EU are mainly governed by the Settlement Finality Directive and the Central Securities Depositories Regulation. The aim of the SFD is to reduce the systemic risks associated with participation in payment, clearing and securities settlement systems, while the CSDR applies to all financial instruments as defined by MiFID II and activities undertaken by central securities depositories, unless it specifies otherwise.
ESMA is of the view that in the short term, the development of new technology, such as DLT, is not impeded by the current EU regulatory framework. However, the implementation of DLT is also affected by broader legal issues beyond financial regulation, such as corporate law, contract law, insolvency law or competition law. ESMA concludes that the development of DLT is still at an early stage and that it is too early to assess the changes that DLT may bring to formulate an appropriate regulatory response at this time. ESMA will continue to monitor market developments around DLT.
The Report is available at: https://www.esma.europa.eu/press-news/esma-news/esma-assesses-dlt%E2%80%99s-potential-and-interactions-eu-rules and the discussion paper is available at: https://www.esma.europa.eu/press-news/esma-news/esma-assesses-usefulness-distributed-ledger-technologies.
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