DLT Needs Interoperability

Shanny Basar

The International Organization of Securities Commissions has warned that the numerous distributed ledger technology networks being developed need to communicate and operate with each other.

Iosco said in a Research Report on Financial Technology that a large number of blockchain proofs of concept are ongoing and even if they are successful, implementation in the securities markets may raise technological, operational, business and regulatory challenges including interoperability between different networks. Financial institutions are likely to implement DLT in parallel with legacy systems.

“In the potential area of application for post-trading settlement, it will be important to ensure interoperability among the systems of all current market participants (brokers, issuers, investors, trading venues and financial market infrastructure operators),” added Iosco. “It is also essential for different DLT networks to communicate and operate with each other.”

Iosco also discussed smart contracts, computer programs on the distributed ledger which are automatically executed once certain conditions have been met. After the execution and verification of the actions triggered by the smart contract, the blockchain is updated. Applications of smart contracts that are currently being explored include trading of securities, settlement and clearing, corporate actions, and management of margin positions and collateral.

For example, last month four international central securities depositories said they are building a blockchain prototype for cross-border mobilization of collateral which should be ready for regulatory scrutiny in the second quarter of this year. The CSDs in the Liquidity Alliance are developing LA Ledger in cooperation with Deutsche Börse.

LA Ledger, which uses blockchain from the Linux Foundation’s open source Hyperledger project, allows the transfer of collateral to be recorded in the books of the sender and receiver in near-time leading to a significant time advantage and cost saving, especially across borders.

Consultancy Aite Group said in a report, Top 10 Trends in Institutional Securities & Investments, 2017: Black Swans Take Flight, that distributed ledger technology is only a physically distributed database with  decentralized control and has to be combined with other IT components, such as operating systems, applications, middleware, hardware, and software, to be used.

“One of the most important reasons that none of the ongoing pilots have been able to move to the production phase is the lack of technology expertise in implementing DLT systems into a legacy environment,” added Aite. “It will take enormous educational effort and at least a few years’ time to have an adequate DLT workforce to support the scale required for industrywide adoption.”

In addition, Aite said the capital markets industry needs to agree on standards, especially around data, and regulators have to design legal, enforcement and governance frameworks.

Iosco agreed that for smart contracts to take root, legal finality must be clear and the smart contract must be enforceable in law. “Another challenge is that smart contracts are deterministic by nature and thereby exclude the flexibility and optionality common in physical contractual agreements, necessitating mechanisms that allow the code to be halted or terminated in certain agreed scenarios,” added Iosco.

In addition, while DLT can be used across borders, regulation is overseen nationally so there is the risk of regulatory arbitrage.

“The emergence of new fintech players that offer innovative financial products and services which sometimes cut across different industries within the wider economy could impact current regulatory perimeters within jurisdictions,” said Iosco.

The rising use of technology may also increase the complexity of supervision, surveillance and enforcement. However, there may also be regulatory benefits through the increase in available data, analytical tools as well as new compliance software and surveillance tools.

The European Securities and Markets Authority said in a report this week that regulatory action on distributed ledger technology is premature while the technology is still at an early stage. The regulator said DLT could bring a number of benefits including more efficient post-trade services, enhanced reporting capabilities and reduced costs.

“Esma expects the early applications of DLT to focus on optimising processes using the current market structure,” said the report. “Likely first areas of use may be less automated processes in low volume market segments and processes with minimum dependency on the existing legal framework.”

However there are also challenges in terms of interoperability, governance, privacy issues and risk creation which may need to be resolved before any large-scale use across financial services. Esma warned: “The development of a new technology, such as DLT, does not liberate users from complying with the existing regulatory framework, which provides important safeguards to ensure the stability and proper functioning of financial markets.”

The regulator believes that the current EU regulatory framework does not represent an obstacle to the use of DLT in the short-term but issues such as the legal certainty attached to DLT records or settlement finality, may require clarification. In addition, broader legal issues, such as corporate law, contract law, insolvency law or competition law, may affect deployment.

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