How to deal with financial regulations in the new generation of Blockchain markets?
An European perspective
TLDR:
Within the EU, operating an exchange of financial products is subject to extensive regulation in terms of licensing, operating, and compliance. This regulation has been designed to maintain a trustworthy environment in a system based on intermediaries.
Using blockchain technology in financial markets brings many benefits to the functioning of the markets and changes the way that trust is ensured by allowing for higher levels of decentralization. As a consequence, the legal framework for financial markets may be ill-suited for certain blockchain-based exchanges.
There’s a need for a review and update of existing regulation to take into account this paradigm shift. However, the wait-and-see attitude of European regulators is not conducive to proactive rule-making and the short-term state-level initiatives have so far proven insufficient and unable to create a healthy and secure framework wherein Fintech companies can grow and innovate.
Introduction
At VariabL, we are about to launch a derivative trading platform on the Ethereum blockchain which embraces smart contracts to improve the derivatives markets and offer decentralized, secure and efficient financial products. VariabL originates from ConsenSys, global leaders in blockchain solutions.
Throughout the process of building this platform, questions have been raised about the impact of blockchain on current market regulations. Here, we share our experience and insights on the challenges and opportunities of integrating new blockchain technologies in the current landscape of European financial regulations. We would like to open the discussion on the perspective and potential hesitations of national financial regulators.
More than an overview of existing issues, this article is a call to redesign market regulations and to take into account the benefits of blockchain technology for exchanges. We are calling for a safe legal framework that allows Fintech companies to experiment and grow with the Blockchain technology in the best way possible.
1. The Trading of Financial Instruments: A Highly Regulated Sector
Our first product is a derivative ETH contract pegged to the ETH/USD exchange rate. To understand how our products may be regulated once they become available for traders, we explored how financial trading is regulated within the European Union.
What is a financial instrument? A financial instrument is a contract that gives rise to a financial asset or equity instrument. According to the EU definition,¹ the category of “financial instruments” includes a large range of products: transferable securities, options, futures, swaps, forward, derivatives and contracts for differences.
Every activity dealing with financial instruments is highly regulated. For example, activities like financial investment advisers and portfolio managers all require preliminary approval by national regulators. This is also true for advertising and marketing of financial products.
One of the most heavily regulated fields is the trading of financial instruments. Since VariabL produces a financial trading platform (more information on our activities, here), we were eager to know the potential regulations it may become subject to.
How are financial instruments traded? There are two main ways to trade financial products. First, they can be traded either over-the-counter (“OTC”) — meaning that they are traded directly between two parties, without the supervision of an exchange. Secondly, they can be traded on organized exchanges and settled under institutional rules.
It is not our intent here to review the regulation surrounding OTC derivatives. They are traded directly between two traders, and are subject to specific requirements. Instead, we will focus on the trading of financial instruments on market platforms.
What are the legal requirements for operating a market in Europe? There are currently different categories of “financial markets”, or “exchanges”². They are multilateral systems, which means they bring together or facilitate the engagement of multiple parties buying or selling interests in financial instruments through contracts. On these platforms, participants can use financial instruments to enter into contracts with each other. Although there are differences in the way these exchanges operate, their common feature is that they are all strictly regulated under European financial law.
With the trading of financial products comes various risks, especially for derivatives: risks for the consumer, and risks for the financial community. Operating or trading on an exchange implies compliance with an extensive variety of regulations, and among them:
- Approval and licensing: the market operator needs to get an approval and licensing from a national regulator, according to specific requirements in terms of operating rules, organisational structure, and human and material resources.
- Operating requirements: once authorized, the exchanges are subject to a certain number of organisational rules, market surveillance and conduct requirements, in order to ensure that the markets are fair, transparent and efficient places, and to provide customer protection.
The legal framework applied to exchanges is explained by the structure of the platforms: they rely on intermediaries, which help ensure the smooth functioning of the market.
The use of blockchain technology in the markets induces a change of paradigm. Since the development of blockchain-based “disintermediation” exchanges, the current regulatory regime appears to be ill-suited to facilitating growth and innovation in the Fintech community.
2. Exchanges Using Blockchain: New Benefits, New Paradigm and an Ill-suited Legal Framework
The blockchain technology brings new properties to the operation of market platforms. new platform that allows participants to enter financial contracts deployed on a blockchain introduces various innovations and brings major benefits compared to traditional exchanges. Regulators have taken note of the numerous benefits of using blockchain technology in financial markets. For example, in February 2017, the ESMA (European Securities and Markets Authority) published a report³ in which the authority listed the “Possible benefits of DLT applied to securities markets”.
The main point is that exchanging through an “on-chain” platform eliminates the need for an intermediary to ensure the execution of the transactions.
Other benefits include enhanced resilience and secured transactions. Thanks to the distributed verification of transactions, there is no need for a centralized trusted third party to hold the funds and verify the transactions. The post-trades processes are more efficient: by using the blockchain, the clearing and settlement of any transaction is accelerated since the trade confirmation as well as the allocation and settlement can be combined in a single step. Furthermore, the enforcement of the transaction does not rely on a third party: transactions are automatically executed on a blockchain. From this, the counterparty risk⁴ and the settlements failures are reduced, as settlement cycles are shorter, which makes unnecessary to mitigate risks through a central counterparty and a collateral posting. Finally, the blockchain enhances reporting, transparency, and facilitates supervision by making data collection and sharing easier.
VariabL trading platform is a good example of what can be achieved through “on-chain” derivatives contracts. VariabL improves derivatives markets and offers more secure and efficient decentralized financial products.
The platform’s critical functions are decentralized, and VariabL does not act as an intermediary for most operations. When participants contract with each other, they send a transaction to the blockchain directly, and the contracts are created on the blockchain. The funds are held in smart-contracts, with immutable conditions previously set-out. When a contract expires, the funds are automatically reallocated according to these conditions, and the only accounts that can receive funds from those positions are those that have created the contracts.
Thus, users always control their funds. Assets are secured in smart-contracts and never handled off-chain. Contrary to a “classic” exchange, the custodian of the funds is always the user. The costs per transaction and of the underlying infrastructure are lower. The recordkeeping and property of the transactions is ensured by the Ethereum blockchain itself, therefore facilitating appropriate regulatory surveillance (more about our features here).
The emerging trust dynamics are not accounted for in existing financial regulations. The European set of rules for regulated markets are designed in order to achieve two major objectives:
- protecting investors and safeguarding market integrity by establishing harmonised requirements governing the activities of authorised intermediaries; and
- promoting fair, transparent, efficient, and integrated financial markets⁵.
The European regulations governing exchanges aim at ensuring that the markets are fair, transparent, and efficient⁶. For this purpose, EU laws established norms on investment services that ensure the integrity of securities markets, the security and safety of the transactions and participants’ funds, and more generally, preserve global financial stability.
From our opinion, the central concept underlying these regulations is the concept of “trust”. The main goal of the regulatory requirements is to maintain a trustworthy environment: trust of the participants in the integrity of the market, trust that the counterparties will be able to and will execute their obligation and follow through on the contract, trust that there is no place for fraud or market manipulation, trust that regulators will have visibility and surveillance capabilities to make sure the preceding characteristics are being achieved. Within an organized market, trust is ensured through various processes: obligation to depose a collateral and obligation to show sufficient financial guarantees. An important way to maintain a trustworthy environment is to ensure the credibility of the various intermediaries who can intervene along the transaction process. This explains the many requirements imposed on the different intermediaries and the participants of the market.
The concept of a decentralized platform based on blockchain technology transforms the classic paradigm of financial exchanges. Blockchain can provide trust through its inherent structure, and may remove the necessity for a third-party intermediary. Previous articles⁷ have described why the blockchain is a “trustless” technology, and this point remains a subject of debate — does the blockchain eliminate the need for trust? Do participants ultimately trust the safety of the technology? We will refrain from engaging in a philosophical discussion on this point. Fundamentally, there is a general consensus that blockchain technologies make it unnecessary to have a trustworthy third-party involved in your transactions. Blockchain disintermediates transactions. Because blockchains are decentralized and immutable, counterparties can transact with each other without the need of a third party for guaranteeing that transactions will be executed, and without requiring financial guarantees from the counterparties.
This fundamental change may make part of the existing regulations ill-suited to the use of blockchain technology.
A few examples of ill-suited regulation. We will give a few examples of how the financial regulations are ill-suited to any platform using blockchain as we do. All the regulations regarding the recording and safekeeping of the transactions⁸, for instance, are ill-suited and redundant: one of the intrinsic features of the blockchain is to provide a public, accurate and secure record of the transaction in real time. To add a supplementary obligation of data preservation would be a burden. On top of that, the way that transaction is recorded through the blockchain is probably the most secure and safe register. All the measures regarding the protection of the client rights⁹ also appear maladjusted. These measures involve various obligations, like to keep distinct registers of the ownership of financial instruments. In a platform deployed on the blockchain like VariabL, the “operator” does not hold the funds, and the ownership is transparent through the shared ledger of transactions. A last example would be compliance. Using blockchain technology in financial markets does not remove the need for compliance and conformity. However, some legal requirements are ill-suited given the fact that the technology eliminates and mitigates numerous risks related to financial instruments. For instance, the risk of fraud is almost non-existent. The risk of counterparty is also mitigated, as seen above. Material mistakes are rare too, since the contracts can be deployed in the blockchain according to conditions existing in the code of the smart contracts, automatically executed without human intervention and audited by everyone. The compliance function will be — with no doubt — redefined by the use of blockchain technology.
We can conclude from these above-mentioned examples, that the current financial regulation of market platforms is ill-suited to the new generation of exchanges based on blockchain technology. The legal requirements are not adequate, because they have been built to maintain the trustworthy environment in a system based on intermediaries. Existing regulations do not provide an appropriate framework to existing and future blockchain projects and should not be applied to those projects as-is.
3. A Call for a New Regulation
All over the world, governments and regulators have become aware of the potential impacts of blockchain technology on financial markets. They are also aware of the need to renew and redesign the regulatory landscape, as shown by the number of reports, public consultations and discussion papers recently published. Europe is no exception¹⁰.
However, there’s very few initiatives — consequence of the hierarchy of legal norms that exists in the European Union. Indeed, the legal framework of blockchain (and the use of the blockchain in financial services and exchanges) will ultimately be defined by the European Parliament and Council. In the meantime, local regulators and local legislators scrutinize the ESMA positions.
European authority: a real interest, but a long wait and see. The ESMA has an interest in blockchain technology, as shown by the initiatives and proposals published during the last year. In June 2016, ESMA launched a public consultation on the use of distributed ledger technology applied to securities markets; which led to a Report in February 2017, aptly named The Distributed Ledger Technology Applied to Securities Markets. In July 2016, the European Commission proposed to bring virtual currency exchange platforms and custodian wallet providers within the scope of the 4th Anti-Money Laundering Directive (these proposals have been adopted in the Parliament in 2017) and also set up an internal task force on financial technology.
As for now, the ESMA adopted a “wait-and-see” position. The Authority considers that the technology is still on its early stage — which is true — and wishes to wait for practical applications to emerge in order to measure the risks and consequences before taking any position.
“At this stage, ESMA believes that it is premature to fully appreciate the changes that the technology could bring and the regulatory response that may be needed, given that the technology is still evolving and practical applications are limited both in number and scope.”¹¹
This is indeed a careful attitude, also justified by the fact that ESMA does not (in theory) want to stifle potential useful applications.
“ESMA’s understanding is that the current EU regulatory framework does not represent an obstacle to the emergence of DLT in the short term. Meanwhile, some existing requirements may become less relevant through time. New requirements might on the contrary be needed to address emerging risks”¹²
The reality is different. The regulatory wait-and-see policies represent a significant obstacle to the first mature projects. Indeed, the regulatory uncertainty is a major deterrent, and may become a strong disincentive for entrepreneurs to move forward, with simple things such as the choice of company’s location or the fact that at any time, a directive or a legal decision can make your activity illegal. This summarizes the paradox of a wait-and-see approach: on one hand, the regulators and legislators do not want to take a position as long as there are no mature projects requesting a regulation. On the other hand, the innovative projects cannot evolve under the constant threat of a future and uncertain regulation, which could question their whole business.
Local regulatory initiatives: short term and uncertainty. In the meantime, we also see appearing national initiatives in the European Union. Some local regulators have expressed their interest for the blockchain innovations in financial markets by releasing press statements¹³, and create specifics divisions to follow-up the blockchain projects impacting financial services. As an example, in June 2016, the French regulator “Autorités des Marchés Financiers” announced a “Fintech division”.
A few local regulators have decided to take a strong position on blockchain issues in financial markets. As an example, the Financial Conduct Authority in the UK created in 2016 a “regulatory sandbox” program, that allows FinTechs to test their business models in the market for three to six months; during this period, they are exempted from many of the regulatory requirements to which they would normally be subjected. This is a recommendable initiative, but a very temporary solution. Sandboxes are intended for testing for a limited duration (3 to 6 months for the FCA sandbox).
Gibraltar government is also considering the introduction of a new legislation, to provide a regulatory framework for DLT initiatives (Proposals for a DLT Regulatory Framework), that should be adopted in January 2018. Putting aside the Brexit consequences, such law would be immediately questioned by a future European directive.
In these conditions, it is difficult for an innovative blockchain project in finance to grow and develop in the EU. The uncertainty is a strong disincentive to go to the market, and the laudable short-term proposals do not seem sufficient to compensate the precariousness of the situation.
We would like to highlight this paradox. The wait-and-see approach consisting in waiting for the first mature projects before regulating is a wise and precautionary approach. However, it also means that the first projects to reach maturity will have to go through a grey and unregulated area. The regulatory evolution needs to be concomitant with technological developments to ensure that innovative projects are not slowed down by legal uncertainty.
It is urgent to build a constructive framework allowing projects to evolve in a safe and stable implantation. Only then, FinTech will be able to test and innovate in order to implement the next generation of financial markets based on blockchain technology. It is commendable that regulators and legislators take up this issue and start to work together with the ecosystem to design a suitable regulation.
¹ Directive 2014/65/EU of the European Parliament and the Council of 15 May 2014 on Markets in Financial Instruments, Section C of Annex I
² Regulated Markets, Multilateral Trading Facilities and Organized Trading Facilities, since European regulation MIFID II (Directive 2014/65/EU of the European Parliament and the Council of 15 May 2014 on Markets in Financial Instruments) and MIFIR II (Regulation (EU) No 600/2014 of the European Parliament and the Council of 15 May 2014 on Markets in Financial Instruments)
³ ESMA, “The Distributed Ledger Technology Applied to Securities Markets”, 7 February 2017, ESMA50–1121423017–285
⁴ The counterparty risk is the risk that a party to a transaction will fail to fulfill its obligations.
⁵ « What is a aim of the directive? », Summary of MIFID Directive
⁶ Ibid
⁷ “The promise of the blockchain — The trust machine”, The Economist, October 31st 2015 / “The Blockchain: What It Is and Why It Matters”, Mohit Kaushal and Sheel Tyle, Brookings press, January 13th, 2015
⁸ The article 16 of the MiFID directive requires that all market operators shall arrange for records to be kept of all services, activities and transactions.
⁹ Article 16 of MiFID directive
¹⁰ ESMA realises that DLT may render some processes redundant or change the role of certain intermediaries through time. 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.” ESMA, Report: The Distributed Ledger Technology Applied to Securities Markets, 7 February 2017 | ESMA50 1121423017–285
¹¹ ESMA, Report: The Distributed Ledger Technology Applied to Securities Markets, 7 February 2017 | ESMA50 1121423017–285
¹² ibid
¹³ “Innovation financière : l’AMF attentive aux projets de développement des registres distribués (DLT) dans les marchés financiers”, publié le 23 juin 2016
