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THE
FINTECH
EDITION
2019
2 of 134
DISCLAIMER
This document has been prepared by the FinTecHub, a student run
organisation which forms part of the Student Support Programme at
the Centre for Commercial Law Studies, Queen Mary University of
London.
This document and the information herein are provided solely for
general information and marketing purposes only and is not intended
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authors or any of the sponsors, nor does it constitute an offer or a
solicitation of an offer to buy or sell any specific security, investment
instrument, product or other specific service, or recommendation or
introduction of any specific investment instrument or financial services
or to effect any transaction or to conclude any legal act of any kind
whatsoever.
Legal advice should always be sought before taking any legal
action based on any of the information provided. Nothing in this
document shall constitute investment, legal or tax advice.
The information provided is based on LLM dissertations and may
not be entirely accurate or verified. No representation or warranty
(expressed or implied) is made as to the information’s accuracy,
sufficiency, completeness or reliability, nor is it intended to be a
complete statement or summary of the developments referred to in it.
All information and opinions expressed in this document are subject to
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expressed by the editors, authors or any of the sponsors (including any
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under no obligation to update or keep current the information contained
herein, and the content herein may not necessarily reflect the present
law. Any charts and scenarios are for illustrative purposes only.
Historical performance is no guarantee for and is not an indication of
future performance. Certain images are from Unsplash.com and the
rights to these images are with their respective creators.
The FinTech Edition © 2019
Editors
Professor George A Walker
Jin Enyi, LLB (Hafnia), Cand.jur, LLM (Lon), HD, PhD Candidate
Assistant
Bella Qiuyu Han, BSc Mathematics
© 2019 FinTecHub. All rights reserved.
This document and its content are protected by copyright and may not (in
whole or in part) be redistributed, reproduced or stored in a data retrieval
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their directors, employees, agents or other affiliates accept or assume
any liability, responsibility or duty of care for any consequences of you or
anyone else acting, or refraining to act, in reliance on the information
contained in this document or for any decision based on it.
Should you have any inquiries please contact [email protected].
This publication contains ATTORNEY ADVERTISEMENT.
First published in June 2019 by
FinTecHub
Centre for Commercial Law Studies, School of Law
Queen Mary University of London
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London WC2A 3JB
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T: +44 (0) 020 7882 8100
W: www.qmul.ac.uk/law/research/students/student-support-programme/
CONTENTS
3 FOREWORD
5 ABSTRACTS
6 THE EMERGING DIGITAL CURRENCY LAW IN CHINA
(Zexing Song)
8 A CRITICAL ANALYSIS OF ICOS AND THE ROLE OF TOKENS, SWITZERLAND’S
REGULATION AS A MODEL
(Gabriele Teodoro)
10 BLOCKCHAIN REVOLUTION AND ITS IMPACT ON THE LENDING INDUSTRY
(Caterina Marinelli)
11 THE WILD-WEST PHENOMENON OF ICOS
(Nabila Iquebal)
13 MUSIC COPYRIGHT MANAGEMENT ON BLOCKCHAIN: ADVANTAGES AND
CHALLENGES
(Tam Ngoc Linh Tran)
15 LEGAL CHALLENGES AND RESPONSES TO DISTRIBUT-ED LEDGER TECHNOLOGY
(DLT) IN THE CLEARING AND SETTLEMENT OF SECURITIES: A STUDY FROM THE COLOMBIAN SECURITIES MARKET AND THE MERCADO INTEGRADO LATINO AMERICANO (MILA)
(Felipe Salazar Acero)
16 REGULATING DIGITAL CURREN-CIES: A COMPARATIVE ANALY-SIS IN THE US, UK, EU AND CHINA
(Ryan P Burton)
18 SELECTED PAPERS
19 COLLUSIVE BEHAVIOR IN PERMISSIONED BLOCKCHAINS
(Ching Tat Chan)
58 DLTS IN CURRENT EU FINANCIAL MARKET INFRASTRUCTURES:
RESTRICTED OR UNRESTRICTED NETWORK? A LEGAL PERSPECTIVE
(Salvatore Pantaleo)
96 DISTRIBUTED LEDGER TECHNOLOGY AND ASSET SECURITISATION: AN ANALYSIS OF
THE BENEFITS AND THE REGULATORY CHALLENGE TO THIS FRAMEWORK
(Victor Da Silveira Vieira)
2 of 134
NURTURING
ACADEMIC AND
PROFESSIONAL
EXCELLENCE
This is the second iteration of the FinTech Edition. This is a dedicated digital academic and professional research journal focusing on the latest developments in the Law of Financial Technology (FinTech) and associated Regulatory Technology (RegTech). These are exciting and fast changing times and areas of current development. Sub-stantial market revision and adjustment is expected in all fields of financial services as a result of the relentless power of innovation and new technology. Change is inevitable. It is only a question of how severe the accompanying disruption will be. Banking and financial services and markets will be materially impacted by major innovation in associated technology. This specifically includes BigTech and CoreTech as well as other continuing areas of advance, for example, in relation to automation and robotics, Big Data analytics, machine read-ing (MR), machine learning (ML), machine intelligence (MI), and artificial intelligence (AI) more generally, as well as quantum computing, nanotech-nology, biotechnology and synthetic biology or cyborgs.
A new digital world has been created which is dominated by the impact of innovation and technology on older legacy systems. A new technosphere has been constructed. New advances continue to be achieved in areas of distributed ledger technology, including blockchain technology, based on decentralisation and distribution, automation and smart function, and with the endless digitalisation, disinter-mediation, dematerialisation, immobilisation and personali-sation of financial products and services.
"THE FUTURE IS NOW”
While this brings substantial benefit, it also results in significant new risk and exposure. A large number of new legal and regulatory challenges have arisen that have still to be properly examined and fully resolved. It is hoped that the FinTech Edition will become a leading reference tool in this area. The articles are made up of a selection of the highest quality research papers produced by exceptionally talented grad-uate Master of Law (LLM) degree students during 2017-2018. An increasingly large number of students wish to research complex issues and advanced problems in the FinTech and RegTech related areas.
We congratulate all of the contributions selected and must thank all of the candidates involved. We would also express our warmest gratitude to Simmons & Simmons and our other partners for supporting our joint collaborative Student Support Programme. We would also thank our dedicated editorial team for all of their work on this and our other continuing research projects. We very much hope that readers and users will find the studies provided in this second edition valuable and insightful and assist their own understanding and command of this complex and difficult subject. The future is now.
Yours faithfully, Dr George A Walker
Professor of International Financial Law Centre for Commercial Law Studies
London, June 2019
FOREWORD
5 of 134
ABSTRACTS
6 of 134
THE EMERGING
DIGITAL CURRENCY
LAW IN CHINA
Zexing Song, LLM
University of Glasgow
For the full paper please contact
With the rise of digital coin technology,
substantial business entities prefer to
apply this technology in the aspect of
financing in order to improve their
business and financial capabilities. The
rising Initial Coin Offering (ICO) projects
generally promise high returns or high
utility value of their issued digital coins (or
private digital coins) that written in the
project whitepapers. However, with the
lack of prompt regulations and legislations
by official authorities, a great number of
fraudulent projects or inferior projects
have participated in the ICO market, which
has incurred losses of investors and has
further amplified financial risks. This
involves the equivocal legal nature of
digital currency and the lack of responsible
regulatory bodies. Besides, most ICO
projects are currently in the initial stage,
the subsequent regulations towards these
projects remain regulatory gaps. There are
also further regulative and legislative
issues with regard to the operation of
digital currency.
This paper aims to give a theoretical
analysis on the forthcoming digital
currency regulation and legislation in
China, with the emphasis of the legal
nature, the macroeconomic impacts and
the possible regulatory and legislative
issues of digital currency. To explain the
necessity of regulating the digital currency
market, the context of digital coins and the
technology within digital coins are
introduced with the evaluation of digital
coin advantages and disadvantages. Also,
the representative countries that
regulating digital currency are presented,
with the focus on Chinese pilot projects
relating to digital currency regulation and
the Central Bank Digital Currency (CBDC
or official digital coins) proceeded by
People’s Bank of China. Next, this paper
proposes a range of feasible regulatory
paths and legislative approaches, following
the reality of Chinese regulatory and
legislative issues. In conclusion, it further
recommends a regulatory balance between
private digital coins and official digital
coins.
7 of 134
ABOUT Rooney Nimmo is an international corporate law firm that specialises in investment, transformation and growth across global markets. Our teams operate from New York, Edinburgh, San Francisco, London, Beijing, Shenzhen and Hong Kong. Acting as legal counsel in transnational matters, our lawyers represent a wide range of clients worldwide, including international banks and other financial institutions, investment funds, governments, established multi-national public corporations, educational institutions and non-profit entities, high net-worth individuals, and start-up enterprises.
CONTACT Rooney Nimmo New Broad Street House 35 New Broad Street London EC2M 1NH United Kingdom +44 (0) 208 629 2150 [email protected] www.rooneynimmo.com
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8 of 134
A CRITICAL ANALYSIS OF ICOS
AND THE ROLE OF TOKENS,
SWITZERLAND’S REGULATION
AS A MODEL
Gabriele Teodoro, LLM
Queen Mary University of London
For the full paper please contact
ICOs and tokens are financial tools based on the
blockchain technology that are revolutionizing the world
of finance. However, the regulatory uncertainty
surrounding these instruments can be exploited by
criminals in order to commit financial fraud. These risks
represent a challenge for financial regulators. This paper
is going to examine the regulatory pattern in three
different contexts: the US, EU, and Switzerland. Then,
after analysing these phenomena and the specific
regulations applied, it will explain the reasons why the
Swiss regulation should be considered a model to follow
internationally.
9 of 134
The European Law Students’ Association (ELSA) is an international, independent, non-political and non-profit
making organisation run by and for students and recent graduates, interested in achieving academic and
personal excellence in addition to their legal or law-related studies.
ELSA Queen Mary University of London and 300 other local ELSA groups span across 375 European law
faculties, consisting of 50,000 members. ELSA QMUL is very active at our university, organising seminars,
conferences, lectures, international study visits, as well as organising socials for our members.
Specific ELSA activities include:
Summer Law Schools of one week’s duration with 40 hours of academic programme, followed by a social
programme. There are 42 different summer law schools covering numerous topics of law such as medical
law, business law, IP law, etc. Find out more at: https://lawschools.elsa.org/
Student Trainee Exchange Programme (STEP) gives students the opportunity to obtain international
legal work experience. Depending on preference, the schemes last anywhere between 2 weeks to 2 months.
The schemes are usually paid or the accommodation for the trainee is provided. Find out more at:
https://step.elsa.org/
Moot Court Competitions consisting of EMC2, is a simulated hearing of a WTO dispute settlement and
European Human Rights Moot Court Competitions (EHRMCC), pleaded before judges at the European Court
of Human Rights. Find out more at: https://emc2.elsa.org/
Delegations are unique opportunities where ELSA delegates are sent to international institutions such as the
UN and WTO. The delegates gain insight to the daily work of recognised international organisations and
experience drafting of international legal documents first-hand. Find out more: https://delegations.elsa.org/
For more information, please visit www.elsa.org
ELSA QMUL contact
E-mail: [email protected]
Facebook: fb.com/elsaqmul
Twitter: twitter.com/elsa_qm
10 of 134
BLOCKCHAIN REVOLUTION AND
ITS IMPACT ON THE LENDING
INDUSTRY
Caterina Marinelli, LLM
Queen Mary University of London
For the full paper please contact
The interactions between individuals, organisations and
countries are regulated by contracts and transactions,
which are the foundation of our economic, legal and
political systems. However, these processes imply
excessively complicated administrative bureaucracies,
which have not been updated over the years. Moreover,
they still rely on inefficient paper documents and third-
party intermediaries, which make them unnecessarily
onerous and expensive.
Blockchain has reshaped the traditional way of
undertaking transactions, introducing innovation and
efficiency. In particular, one of its advantages is the
possibility to record data permanently, stored with a
digital signature in shared and transparent databases that
are impossible to tamper with. Therefore, there is no need
for intermediaries.
This dissertation aims to verify how this revolution will
affect the lending industry, identifying the inefficiencies of
the current processes of raising money and demonstrating
how blockchain is able to fix them and improve their
efficiency.
In doing so, this dissertation answers the question of how
blockchain has impacted on the lending market, in
particular demonstrating how it improves three different
areas of lending, i.e. corporate lending (analysing two
such lending types, namely equity crowdfunding and peer
to peer lending), retail lending and lending in the
wholesale market, examining the syndicated loan market.
11 of 134
THE WILD-WEST
PHENOMENON OF ICOS
Nabila Iquebal, LLM
Queen Mary University of London
For the full paper please contact
Blockchain technology is revolutionising the
world. Since the first Initial Coin Offering in 2013,
more than 21 billion dollars have been raised to
date. Although the importance of Initial Coin
Offerings is undeniable, little attention has been
paid to both the “economic and regulatory
landscape” of Initial Coin Offerings. This paper
aims to answer: To what extent should tokens be
regulated? This will be gauged by looking at the
valuation of crypto-assets, and the regulatory
approach regarding Initial Coin Offerings by the
United States of America, the European Union
and the United Kingdom. Overall the current
situation for Initial Coin Offerings is not optimal
for both investors and companies. Hence, specific
Initial Coin Offering regulation is necessary and
urgent. Moreover, it is crucial that the chosen
approach does not hinder innovation. Bearing
that in mind, the regulatory approach suggested
is a model based on the ideas of disclosure and
transparency that addresses the predominant
risks of Initial Coin Offerings, namely, investor
and consumer protection, financial stability,
money laundering and terrorism-financing.
12 of 134
– INSPIRING THE NEXT GENERATION –
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E-mail: [email protected]
www.qlegal.qmul.ac.uk/resources/ www.qlegal.qmul.ac.uk/advice/
13 of 134
MUSIC COPYRIGHT MANAGEMENT
ON BLOCKCHAIN: ADVANTAGES
AND CHALLENGES
Tam Ngoc Linh Tran, LLM
Queen Mary University of London
For the full paper please contact
The emergence of music blockchain-based platforms is
revolutionising the music landscape. These platforms can
enable rightholders to transact directly with users without
the need for the middlemen, namely collective management
organisations. It is expected that blockchain could help to
solve the historic problems, which are associated with the
dominant position of such intermediaries in the right
management system. However, blockchain still attracts
much debate on its practical constraints. Meanwhile, the
music community is still left in the dark of blockchain’s legal
implications. Accordingly, the benefits and drawbacks of
blockchain application in the management of copyright and
related rights are investigated in this research.
Concurrently, this research adds to the current sparse
literature on blockchain’s legal aspects by examining the
new form of right management on blockchain and analysing
its associated legal obstacles. On this basis, the
understanding of the real promise of blockchain application
in the music industry can be elevated. In addition,
recommendations are presented with a view to ameliorating
the legal barriers of blockchain-based platforms.
14 of 134
15 of 134
LEGAL CHALLENGES AND RESPONSES TO DISTRIBUTED
LEDGER TECHNOLOGY (DLT) IN THE CLEARING AND
SETTLEMENT OF SECURITIES:
A STUDY FROM THE COLOMBIAN SECURITIES MARKET
AND THE MERCADO INTEGRADO LATINO AMERICANO
(MILA)
Felipe Salazar Acero, LLM
Queen Mary University of London
For the full paper please contact
New technology has changed the way we perceive financial services today. New technology
companies are taking part in a new market, offering different alternatives to allocate and channel
resources through the use of apps and internet platforms. Mobile payment, issuance of securities,
asset management and money transfer are some of the sectors where traditional finance services
are migrating to a new types of virtualized financial markets that are growing day by day. These
new alternatives could bring efficiencies, as well as cost reduction in capital flows within the
economy, but they also may create systemic risks thanks to the lack of regulations and
supervision, which has permitted a regulatory arbitrage with high potential to affect financial
market stability.
Post-trading of securities, particularly clearing and settlement infrastructure is one of the most
popular areas where the use of Distributed Ledger Technology is being contemplated, in efforts to
reduce intermediations and costs in the value chain and to increase efficiencies in the entire
process. This article analyses the legal implications and explores the challenges that regulators
should consider when migrating to this new technology applied to the post-trading infrastructure,
mainly focused in Colombian capital market and The Mercado Integrado Latinoamericano (MILA).
16 of 134
REGULATING DIGITAL
CURRENCIES: A COMPARATIVE
ANALYSIS IN THE US, UK, EU
AND CHINA
Ryan P Burton, BA (Wash), LLM (LG), LLM (Glas)
University of Glasgow
For the full paper please contact
After the creation of the notorious Bitcoin cryptocurrency,
an increased number of digital currencies have proliferated
due to the attractive peer-to-peer and decentralized
structure. This has created an abundance of challenges for
regulatory authorities on a national and international level.
In the ever-developing sphere of FinTech and digital
currencies, the mass emergence of new terminology has
led to inevitable misunderstandings and misuse of terms
by individuals, institutions and governments. In law,
precision of words both written and spoken is essential.
Often when cutting-edge technological innovations arise,
laws and regulation can’t keep pace with the fast-changing
new technology. Clarification and harmonization in
defining these terms can reduce confusion and create a
less complicated environment to develop appropriate legal
remedies to efficiently manage the new digital era. This
paper seeks to conduct an overview of FinTech and its
many applications, analyze the legal distinction between
cryptocurrencies as actual currency versus a security
interest, provide a comparative analysis of the legal
framework of cryptocurrencies and ICOs in the US, EU, UK,
and China, and offer proposed remedies to mitigate risk
without stifling innovation.
17 of 134
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full and innovative legal
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Tel: +86 010 6338 9941
No 1115A, Building B, Langqin
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18 of 134
SELECTED PAPERS
1. COLLUSIVE BEHAVIOR IN PERMISSIONED BLOCKCHAINS
Ching Tat Chan, LLB, LLM
Degree awarded with distinction by Queen Mary University of London
Contact: [email protected]
2. DLTS IN CURRENT EU FINANCIAL MARKET INFRASTRUCTURES:
RESTRICTED OR UNRESTRICTED NETWORK? A LEGAL PERSPECTIVE
Salvatore Pantaleo
Degree awarded with distinction by Queen Mary University of London
Contact: [email protected]
3. DISTRIBUTED LEDGER TECHNOLOGY AND ASSET SECURITISATION:
AN ANALYSIS OF THE BENEFITS AND THE REGULATORY CHALLENGE TO THIS FRAMEWORK
Victor Da Silveira Vieira, LLM
Degree awarded with distinction by Queen Mary University of London
Contact: [email protected]
19 of 134
COLLUSIVE BEHAVIOR IN PERMISSIONED BLOCKCHAINS
Ching Tat Chan
ABSTRACT
This paper identifies several collusive behavior that firms may engage within permissioned blockchains.
It examines how firms may exploit the architecture of blockchain such that it becomes possible for them
to participate in such conducts. It analyzes the applicability of EU competition law in these scenarios and
argues that the existing law should be able to deal with the challenges posed by the technology rather
comfortably. The purpose of this paper is to identify the antitrust pitfalls in permissioned blockchains so
that users of blockchain technology may understand the legal risks the use of the technology may pose.
20 of 134
TABLE OF CONTENTS
1. Introduction
2. Chapter One: Blockchains i. Distributed Ledgers ii. Shared Control of Data iii. Participation Criteria iv. Consensus Protocols v. Immutability vi. Conclusion
3. Chapter Two: Explicit Collusion i. Explicit Collusion ii. Cartel & Information Exchanges iii. Cartel, Smart Contract & IOT iv. Collective Boycotts v. EU Competition Law Application
4. Chapter Three: Concerted Practice
i. Concerted Practice & Information Exchanges ii. Information Exchanges in Permissioned Blockchains iii. EU Competition Law Application
5. Chapter Four: Anticompetitive Foreclosure
i. Consensus in Blockchains ii. Consensus Protocols in Permissioned Blockchains iii. Foreclosure in Permissioned Blockchains iv. EU Competition Law Application
6. Further Research
7. Conclusion
Bibliography
21 of 134
INTRODUCTION
Blockchains is one of the buzzwords in 2017. Their best-known use is for cryptocurrency such
as Bitcoin, which its unexpected rise and fall has led to increased public interest in digital currencies in general
and their underpinning technology.1 While commentators remain skeptical about cryptocurrency’s long-term
viability, it is well recognized that the technology underpinning Bitcoin – Blockchain – has potential for far
broader applications. It has been suggested that “the way blockchain-based currency transactions create fast,
cheap and secure public records means that they also can be used for many non-financial tasks”. 2
Consequently, some have already been investigating the possibility of applying the technology in areas such
as e-voting, land registry, and the supply chains. While some of these initiatives are government-led, most of
them are funded by private companies.
Indeed, there is a growing number of firms working together to develop commercial applications
using the technology. It is increasing popular for firms to form blockchain consortia, i.e. a group of companies
that join together, seeking to develop and deploy business solutions based on blockchain technology. It has
been estimated that currently there are more than 40 blockchain consortia globally, some of which are formed
by industry leaders.3 An example is Digital Trade Chain (DTC), a blockchain consortium formed by 8 leading
European banks including HSBC, Société Général, UniCredit, and Banco Santander that aims at facilitating
domestic and cross-border commerce for European companies by leveraging the blockchain technology.4
Recently, the consortium announced the establishment of a Joint Venture company, we.trade, that will be
responsible for managing the DTC blockchain network.5 Another example is the R3 blockchain consortium.
Launched in 2015, over 80 of the world’s largest financial institutions, such as HSBC, Bank of America, and
Merrill Lynch, and central banks come together for the purpose of developing blockchain applications to
1 BBC, ‘Bitcoin falls below $6,000’ (BBC News, 6 February 2018) <https://www.bbc.co.uk/news/technology-42958325> last accessed 14 August 2018 2 European Parliamentary Research Service, How Blockchain Technology Could Change Our Lives (Science and Technology Options Assessment 2017) 4 3 Deloitte University Press ‘Banding Together for Blockchain: Does It Make Sense for Your Company to Joint a Consortium?’ (Deloitte University Press 2017) 2 4 KBC Group, ‘KBC and Cegeka Trial Ground-Breaking Blockchain Application for SMEs’ (KBC Group, 12 July 2016) <https://newsroom.kbc.com/kbc-and-cegeka-trial-ground-breaking-blockchain-application-for-smes> last accessed 14 August 2018; The eighth bank, Banco Santander, joined in 2017 5 KBC Group, ‘Digital Trade Chain Consortium Launches we.trade, Announces Joint Venture and Welcomes Santander’ (KBC Group, 17 October 2017) <https://newsroom.kbc.com/digital-trade-chain-consortium-launches-wetrade-announces-joint-venture-and-welcomes-santander> last accessed 14 August 2018
22 of 134
address specific business challenges in different industries, including shipping, healthcare, insurance and
financial services. As such, it seems there is a trend that firms are “banding together for blockchain”.6
While in general the emergence of blockchain consortia is a good idea in the sense that everyone is
contributing to release the full potential of the blockchain technology, the fact that firms, especially industry
leaders, are now “assembling together” for blockchains may seem odd for antitrust regulators.7 As with any
new technology, competition authorities are paying close attention to the development of the blockchain
technology. Indeed, two aspects of the technology may raise competition concerns. Firstly, blockchains as a
digital distributed ledger. From a competition law perspective, particularly when several competitors are found
sharing the same blockchain network, such functionality may be regarded as a mechanism to coordinate
collusive behavior because members of the blockchain network may share sensitive information that is capable
of reducing the strategic uncertainty in the market. Secondly, the ‘decentralized’ nature. One of the key
characteristics of the technology is that multiple parties may interact with each other directly without the
presence of a trusted single entity. In enabling this, there are mechanisms in place that help members of a
blockchain network to reach consensuses before making collective decisions. However, it might be the case
that such mechanisms could be exploited by members a blockchain network such that certain members could
no longer use the network effectively. As such, firms may engage in some conducts in blockchains that may
go against competition law principles, and thus prohibited by competition authorities.
This paper aims to identify the antitrust pitfalls in permissioned blockchains and discuss the
applicability of EU competition law in this regard. While the relationship between permissionless blockchains
and competition law is equally interesting, this paper focuses only on permissioned blockchains. Moreover,
the focus of the paper is on competition issues that arises from the architecture of the blockchain technology.
In other words, competition concerns that are unique to blockchains. As such, other antitrust considerations,
such as standard setting and unilateral conduct by a dominant firm, will not be discussed.
6 Deloitte University Press (n 3) 2 7 Adam Smith once famously said: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivances to raise prices […] But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies, much less to render them necessary”; Adam Smith, The Wealth of Nations (Book IV, Chapter VIII, W.Strahan and T. Cadell 1776) 660
23 of 134
The paper is divided into four chapters. After this Introduction, it commences by providing an overview
of the blockchain technology. In Chapter Two, it explores explicit collusion in the context of permissioned
blockchains. Chapter Three discusses how members of a blockchain network may share information on a
blockchain, while Chapter Four focuses on anticompetitive foreclosure that take place in a permissioned
blockchain. Before ending with a conclusion, the paper explores other areas that is worth to conduct further
research.
24 of 134
CHAPTER ONE: BLOCKCHAINS
This Chapter provides an overview of the blockchain technology. In general, the technology presents five
key characteristics which can be understood in terms of (a) distributed ledgers, (b) shared control of data, (c)
participation criteria, (d) consensus protocols, and (e) immutability. These features will be outlined in turn below.
The Chapter concludes by providing a summary of how a typical blockchain network run.
Distributed Ledgers
At its simplest, blockchains are digital ledgers that combine certain cryptographic technologies.8
Blockchains can be utilized to record every type of transaction involving value, including money, goods and
property. In the case of Bitcoin, the technology is being used to store the details of every transaction and stops
the same Bitcoin from being ‘double spent’. However, rather than being maintained and stored by a central
entity, this digital ledger is ‘distributed’ to all members of the network. In essence, information that is stored in
a blockchain network will be automatically replicated and shared among the users of the network. In other
words, blockchains enable sharing of data.
Shared Control of Data
In fact, the need of ‘sharing of data’, whether users need to have data access in real-time or not, has
already been solved prior to the invention of blockchains. Consider Cloud Storage. In general, it enables users
to upload data to a network of remote, connected servers, which can then be accessed, modified and shared
across multiple devices by the users. The technology here typically does not involve the blockchain technology.
Being a distributed ledger at its core, a blockchain is capable of sharing data, although the mechanism is
different from the one that is used in Cloud Storage. However, central to the blockchain technology is not the
notion of ‘sharing of data’.
What is fascinating about blockchains is that it enables ‘shared control of data’. This is a new notion. In
the past, data on a digital database is controlled by a single entity.9 As such, at technical level, the stored data
can be modified only when the controlling authority executes the request. For example, in Cloud Storage,
8 In other words, while blockchains are a form of distributed ledgers, it is not true that all distributed ledgers are blockchains. To qualify as a blockchain, a distributed ledger must deploy certain technologies, in particular the hash function. 9 Amazon Web Services (AWS), ‘Cloud Storage’ (AWS, 2018) <https://aws.amazon.com/what-is-cloud-storage/> last accessed 14 August 2018
25 of 134
although it seems users have control over their own data, the stored data is ultimately controlled by the entity
which maintains the severs, although its activities will be constrained by legal and contractual obligations. In
other words, when a user ‘modifies’ his/her own data, the changes are actually made by this single entity.
Accordingly, it can be said that we typically rely on a trusted authority to maintain our records.
In blockchains context, rather than putting control on the hands of a single entity, data are jointly controlled
by the parties according to a set of pre-agreed rules, known as ‘consensus protocols’. In general, consensus
protocols are sets of rules that facilitate members of a blockchain network to reach a consensus regarding how
data should be handled, in particular whether a proposed transaction should be appended to the blockchain.
Accordingly, control is shared in the sense that the power of how data should be dealt with is not vested in a
single entity, but on the hands of all members of the network.
Participation Criteria
In general, there are three types of members in a blockchain network.10 Firstly, the ‘miners’. These are
members who assemble data (e.g. transactions) into blocks and propose blocks to be added on the blockchain.
Secondly, the ‘nodes’. These members are responsible for storing the ledger and validating new blocks. Lastly,
the ‘users’, who are the end users of the functionality of the blockchain technology.
Blockchains can be largely categorized into two models, namely permissionless and permissioned.11 The
only difference between these models relates to who can participate in what. In the permissionless model,
anyone is free to join the network, free to propose new blocks, and free to maintain the ledger. In other words,
such model is completely open such that anyone can be a miner, a node, or a user. An example of the
permissionless model is Bitcoin.
The permissioned model on the other hand can be understood as a closed platform with a defined number
of participants. Typically, only authorized parties can join the network. Therefore, members in the network are
usually known and trusted by each other. Permissioned blockchains can be configured to impose further
10 Jean Bacon and others, ‘Blockchain Demystified’ [2017] Queen Mary University of London, School of Law, Legal Studies Research Paper No. 268/2017, 20 – 21 11 Ramesh Gopinath, ‘Checking the Ledger: Permissioned v.s. Permissionless Blockchains’ (IBM, 28 July 2016) <https://www.ibm.com/blogs/think/2016/07/checking-the-ledger-permissioned-vs-permissionless-blockchains/> last accessed 14 August 2018
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restraints on the power of the members. Depending on the set-up of the blockchain, it is possible to limit the
power of proposing new blocks and the power of storing the ledger to only a small number of parties.
Consensus Protocols
As mentioned, how data should be handled on blockchains is based on ‘consensus’. In general, before a
miner could propose a new block to be added on the blockchain, he must demonstrate some sort of
‘faithfulness’ such that the proposed block represent the ‘true version’ of the information and he is not malicious.
The nodes will then verify the proposed block individually and, at the end, come to an agreement regarding
whether this block should be appended on the blockchain. Should the nodes validate the block, it will be added
on the blockchain. Otherwise, it will be rejected and sent back to the pool of blocks. The precise rules of a
consensus protocol vary according to the needs of the members of a particular blockchain network, although
consensus protocols such as ‘proof of work’, ‘proof of stake’, and ‘practical Byzantine fault tolerance’ are
commonly used by the blockchain community.
Immutability
Blockchains are immutable in the sense that the content and sequence of the stored data cannot be altered
without being easily detected by other parties in the blockchain. Two elements are key here.
Firstly, hash function. It is a software that converts digital inputs (e.g. a block of transactions) into a string
of digits. This string of digits is known as hash value and is unique to that data item. In other words, the hash
value is effectively the fingerprint of that data item. Importantly, hashing is ‘one-way’ in the sense that it is not
possible to recreate the original input from its hash value. Moreover, if the input data is being modified even in
the slightest, its hash value will be changed as well.
Secondly, blocks. As suggested by its name, data are stored in a blockchain in blocks. Each block thus
contains a bundle of data (e.g. transactions records). However, in addition to data, each block in fact contains
some other items, most notably the hash of the previous block. In other words, the fingerprint of the previous
block is included and forms part of the subsequent block. As a result, this fixes all existing blocks and a tamper-
evident chain of blocks is formed – contents within a block cannot be altered without changing the hash value
of the block. However, any attempt to ‘re-hash’ the block will break the chain between itself and the subsequent
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block as the latter contains the original hash value of that block. Therefore, any tampering will be obvious to a
viewer. Furthermore, as the blockchain technology enables the ledger to be replicated and stored in multiple
locations, this means that all copies of the chain will need to be changed in the same way.
Lastly, it is important to note that data on blockchains is by default not encrypted. Especially when the set-
up of the blockchain requires nodes to certify new blocks, the nodes will need access to the content in the
blocks in order to cross-check with its own local copy of the ledger.
Conclusion
This chapter will be concluded by showing how a typical blockchain network run: (a) After being
authenticated, users of a blockchain network may submit a request to the blockchain network. (b) The message
will be picked up by miners who will pack several transactions together into a block. Miners will then broadcast
this block back to the network and propose it should be added on the blockchain (c) Upon the receipt of the
suggested block, the nodes will verify whether the block contains the valid transactions and references via
hash the correct previous block on their chain.12 (d) Where the nodes come to an agreement that they are
satisfy with the block, they will add the block to the blockchain. Otherwise, the proposed block will be discarded.
12 Konstantinos Christidis and Michael Devetsikiotis, ‘Blockchains and Smart Contract for the Internet of Things’ (2016) 4 IEEE Access 2292, 2293
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CHAPTER TWO: EXPLICIT COLLUSION
This Chapter examines explicit collusion in the context of blockchains. The Chapter will first
provide the definition of ‘explicit collusion’. After that, it discusses three forms of explicit collusion, namely
information exchanges, Smart Contracts & IOT, and collective boycotts. It is then followed by an analysis of
these scenarios under the EU competition law.
Explicit Collusion
Explicit collusion occurs where “undertakings collude, collectively, to exploit their joint economic
power and to improve their profitability”. 13 Explicit collusion may take the form as an anticompetitive
agreement or an anticompetitive concerted practice. Central to notion of ‘explicit collusion’ is that there is direct
communication between the undertakings with the intention to coordinate and/or monitor each other’s actions
for the purpose of raising profits above competitive levels.
Of all explicit collusion arrangements, cartels are seen as the “supreme evil of antitrust”.14
Cartels are explicit attempts to eliminate competition in the market without producing any pro-competitive
effects. Firms to a cartel typically employ means such as price fixing, allocation of production quotas, or sharing
of geographic markets or product markets for the purpose of transferring wealth from consumers to themselves.
These conducts undermine the free market economy and thus provoke hostile reactions from competition
authorities.
Because of the strong attitude of competition authorities towards cartels, it is almost impossible
to identify cartels nowadays. On the bright side, this shows that competition authorities have successfully
created a competition culture, thereby firms are deterred from engaging in conducts that would severely harm
the competition landscape of a market. However, it may also argue that cartels nowadays are working in
secrecy, thereby avoiding being detected by the authorities. Therefore, theoretically, cartels still exist, and it is
likely that they are evolving as well. Blockchains is a buzzword in recent years. As such, there may be a case
that firms may exploit the technology for the purpose of facilitating their collusive behavior
13 Alison Jones and Brenda Sufrin, EU Competition Law: Text, Cases, and Materials (6th edn, OUP 2016) 650 14 Verizon Communications, Inc. v Law Offices of Curtis V. Trinko, 124 S. Ct. (2004) [879]
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Cartel and Information Exchanges
The successful operation of a cartel is dependent on various factors. One of which is effective
mechanisms for coordination.15 After parties have agreed on the course of action that is to be taken on the
market, it is then for them to implement the agreement. In doing so, there is the concern that firms in a cartel
may cheat on the agreement, knowing that, according to the prisoners’ dilemma,16 it will profit the most if it
charges a low price while its competitors are charging a high price. Hence, cartels would design measures to
monitor output and prices of individual certain members in order to detect cheating. In some cases, however,
these measures may detect cheating but in fact it is the market condition that affects the result.17 Building
trust among members is therefore difficult for cartels as, at the least, it may be hard to tell whether or not
someone is cheating. As such, it is essential to have effective mechanisms to facilitate coordination among
the firms.
In this regard, blockchains may represent a solution. The idea is that a blockchain may be
employed solely for the purpose of exchanging strategic information. In the context of explicit collusion,
members of cartel may first agree on the course of action that is to be taken on the market. This will then be
followed by the creation of a permissioned blockchain to exchange sensitive information, such as prices and
sales. Information exchanges in blockchains will be discussed in detail in the next chapter in the context of
concerted practice.
For cartels, the use of permissioned blockchains may enhance coordination between members.
First and foremost, only authorized persons would be able to access to a permissioned blockchain. The then
satisfy the need of secrecy for cartels. Moreover, in blockchains, information is shared directly between the
members without the presence of middlemen. Consequently, this lessen the possibility of miscommunication
or tampering by third parties. Furthermore, blockchains could be transparent in the sense that all information
could be available to all members in the network in real-time. It is believed this would promote trust among
members and reduce the incentive to cheat on the cartel agreement.
Cartels, Smart Contract, and Internet of Things
15 Margaret Levenstein and Valerie Suslow, ‘What Determines Cartel Success?’ (2006) 44(1) Journal of Economic Literature 43, 45 16 ibid. 17 Ibid. 71
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Alternatively, cartels may combine the blockchain technology with smart contracts and Internet
of Things to run a cartel more effectively. Where a smart contract and Internet of Things is placed on a
blockchain, automate process will be enabled.
A smart contract is “a computerized transaction protocol that executes the terms of a contract”.18 In
other words, contractual clauses are translated into computer code which will then be placed on a computer
program that allows it to self-execute. In fact, computer codes that enable automate processes is not a new
concept – we have been able to do the same ever since computers are invented. One example is the monthly
direct debits out of a bank account. However, modern smart contracts take such coding, and combine it with
the potential of the blockchain technology.
Placing a smart contract on a blockchain means this set of computer code will run in an interoperable
and incorruptible computer program. In blockchains context, the computer code executes independently and
automatically on every node in the network in parallel once the predetermined terms and conditions are met,
in particular when the triggering and output events have been checked and verified by the participants.19 As
such, the execution of the smart contract is not controlled by a single entity. Instead, multiple parties are jointly
responsible to update the computer code in order to trigger the automate process and to approve whether the
process should be triggered. Moreover, the computer code is replicated and shared among all members,
rather than within the hands of a single entity. This does not only allow authorized parties to see the computer
code, but more importantly any attempts to modify the computer code will be visible by other participants in
the network. Therefore, should anyone wish to alter the computer code, this must be done jointly by the
members of the blockchain network.
The Internet of Things (IOT) is another technology that is becoming increasingly popular. In
essence, IOT can be understood as “the interconnection via the Internet of computing devices embedded in
everyday objects, enabling them to send and receive data”.20 This network of interrelated electronic devices
18 Nick Szabo, ‘The Idea of Smart Contracts’ (Nick Szabo, 1994) <http://www.fon.hum.uva.nl/rob/Courses/InformationInSpeech/CDROM/Literature/LOTwinterschool2006/szabo.best.vwh.net/idea.html> last accessed 14 August 2018 19 Konstantinos Christidis and Michael Devetsikiotis (n 13) 2296 20 Jon Wood, ‘Blockchain of Things – Cool Things Happen When IOT & Distributed Ledger Tech Collide’ (Medium, 20 April 2018) <https://medium.com/trivial-co/blockchain-of-things-cool-things-happen-when-iot-distributed-ledger-tech-collide-3784dc62cc7b> last accessed 14 August 2018
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is typically employed for the purpose of collecting data in its surrounding area, monitoring remotely, or even
interacting with other similar devices and make decisions without human intervention.21 The blockchain
technology may further enhance the functionality of IOT in two ways. Firstly, by placing IOT on a blockchain,
IOT users may then have a verifiable, immutable, and secure method of recording data processed by these
devices. The activities of these devices will also become visible to users. Secondly, it is possible to link
blockchain-based smart contracts by the IOT, thereby enabling automated processes, for example large scale
remote systems management.
It is argued that the combination of the above technologies is particularly appealing to cartels.
Where a blockchain-based smart contract is being used by cartels, firms not only can share information more
efficiently, they could also codify the cartel agreement into the blockchain. As a result, where punishment
mechanisms are agreed into the agreement, the blockchain-based smart contract enable firms to enforce the
punishment more effectively.22 More specifically, when certain conditions indicate that some members deviate
from the agreement, the inserted punishment mechanisms will be triggered, and compensation from the
cheating members will be automatically made to the cartel. As the smart contract is implemented on a
blockchain, there will be no single source of control in relation to cartel agreement. Therefore, unless all other
members approve, the cartel agreement cannot be modified. Consequently, the credibility of the punishment
is increased and the incentives to cheat is deterred. Furthermore, with IOT being connected to a blockchain-
based smart contract, cartel members’ behavior can be monitored by its fellow members remotely and directly
through these smart electronic devices, rather than relying on each other’s self-reporting. When these devices
collect data that signifies that certain members are cheating on the cartel agreement, such data may trigger
the smart contract to impose punishment on these members. As such, for cartels, the combination of IOT,
smart contracts, and blockchains ensures members commit to the agreement and improves the accuracy of
information in relation to members’ behavior.
Collusive Boycott
21 Margaret Rouse, ‘Internet of Things (IOT)’ (IOT Agenda, June 2018) <https://internetofthingsagenda.techtarget.com/definition/Internet-of-Things-IoT> last accessed 14 August 2018 22 Harrington observed that enforcing punishment in cartels may not be as straightforward as first thought. In some cases, some firms may be reluctant to make compensation; Joseph Harrington, ‘How Do Cartels Operate?’ (2006) 2(1) Foundations and Trends in Microeconomics 1, 59
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Moving away from cartels, explicit collusion in permissioned blockchains may take the form of
collective boycotts. A collective boycott can be understood as an agreement between a group of competitors
to “exclude an actual or potential competitor”.23 In the blockchains context, a firm may be excluded by other
members of the network via the consensus protocols.
Central to the blockchain technology is the idea of ‘shared control’. As such, whether a
transaction can be settled depends on whether members of the blockchain network agree that the transaction
should be settled. In blockchains language, when a miner proposes a new block to be appended on the
blockchain, the block in question will need to be verified by the nodes independently. The block would only be
added on the blockchain if the nodes reach a consensus regarding its validity. The question is then how much
consensus is required. Normally, in permissioned blockchains, a consensus is reached if 2/3 of the nodes
agree on the same matter24. In other words, a unanimous decision is not required. Accordingly, it is argued
that some firms may utilize this 1/3 ‘buffer’ to exclude their competitors. More specifically, these firms may
agree among each other that they would not verify certain members’ transactions. Alternative, where the they
are not the nodes of the network, they may instruct the nodes to do the same.
EU Competition Law Application
Explicit collusion fall within the scope of, and is prohibited by, Art. 101 TFEU.25 In general, the
provision prohibits certain joint conduct between two or more undertakings “which have as their object or effect
the prevention, restriction, or distortion of competition”.26 While the blockchain technology, along with smart
contracts and IOT, are relatively new concepts, it is argued that existing laws remain applicable to cases where
these technologies are involved.
The notion of ‘agreement’ in EU competition law has been broadly construed. In Bayer, the
Court summarized the notion of ‘agreement’ as emanated in EU case law and suggested that the notion
“centers around a concurrence of wills between at least two parties, the form in which it its manifested being
unimportant so long as it constitutes the faithful expression of the parties’ intention”.27 As such, the notion of
23European Commission, ‘Guidance on Restrictions of Competition “By Object” for the Purpose of Defining Which Agreements May Benefit from the De Minis Notice’ (SWD(2014) 198 final) 11 24 The mechanisms of consensus protocols in permissioned blockchains will be discussed in detail in Chapter Four 25 Article 101 of the Treaty on the Functioning of the European Union 26 ibid. 27 Case T-41/96 Bayer v Commission [2000] ECR II-3383 [69]
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agreement is rather non-formalistic. This then allows competition authorities to utilize the notion in more
imaginative ways. For example, in AEG-Telefunken, the Court confirmed that an agreement exists even if it
was imposed by one party on another unilaterally.28 Crucial to the notion of ‘agreement’ is therefore not the
form taken by the agreement but a joint intention to behave in a way that would restrict competition.
In blockchains context, it then seems firms may ‘accidentally’ ‘agree’ into an anticompetitive
collusion in various ways. For example, the mere fact that a firm agree to participate in a network that aims to
facilitate an anticompetitive agreement may satisfy the element of ‘agreement’. In Cement, it was held that “it
is sufficient for the Commission to show that the undertaking concerned participated in meetings at which anti-
competitive agreements were concluded, without manifestly opposing them, to prove to the requisite standard
that the undertaking participated in the cartel […] The principles […] also apply to participation in the
implementation of a single agreement”.29 Putting this in blockchains context, it appears that where a firm joins
a blockchain network that is set up for the purpose of conducting some anticompetitive collusive activities, it is
argued that such firm will be deemed as one of the participants to that agreement simply because it became
one of the members of the blockchain network even if it actually has no intention to put the agreement into
effect. This remains true even if the firm is capable of adducing evidence showing that its behavior did not
reflect the terms of the agreement, and thus arguing that it did not participate in that agreement. Another
scenario concerns the situation where firms are already in a blockchain network but the anticompetitive
agreement emerges subsequently. A collective boycott case may illustrate this scenario. For example, a
blockchain which contains 9 firms is launched for facilitating normal business operations. Five of the firms
decide to boycott three other members of the network with the remaining firm did not indicate whether or not
it would participate in this collective boycott. According to Cement, it would appear that the mere fact that the
firm remain in silence is sufficient to establish that it is one of the participants to the agreement as it “has given
the other participants to believe that it subscribed to what has decided there and would comply with it”.30 As
such, firms must not only be careful not to explicitly agree to participate in anticompetitive agreements, they
must also mindful of falling into what is known as “passive mode of participation”.31
28 Case 107/82 AEG-Telefunken v Commission [1983] ECR 3151 29 Cases C-204, 205, 211, 213, 217, and 219/00 P, Aalborg Portland AS v Commission [2004] ECR I-123 [81] – [83] 30 ibid. [82] 31 ibid. [84]
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Where it is established that firms are engaging in an explicit collusion, there should be no
dispute that the use of blockchains would not afford a defense. Inherently, blockchains are merely distributed
ledgers. As such, no matter how transformative it may seem, a blockchain is not capable of self-learning. As
such, where anticompetitive agreements are found, humans, instead of the technology, remain as the ‘master-
mind’ of the collusive behavior in question. Where firms exploit the technology to run the cartel more effectively,
a blockchain is simply being used as an ‘extended arms’ of the firms in the sense that “cartel members program
the computers to help effectuate the cartel, and monitor and punish any deviation from the cartel
agreement”.32 This is to be contrast to the “Digital Eye” scenario, whereby “the machines, through self-learning
and experiment, independently determine the means to optimize profit”.33 In other words, computers in the
latter scenario is capable of engaging in ‘collusive behavior’ automatically on behalf of humans. However, in
the blockchains context, humans, as opposed to artificial intelligence, remain to be the main actors, and are
responsible to make decisions. This is still the case even where IOT is involved as these electronic devices
are involved just for the purpose of monitoring any deviation, thereby ensuring the success of the cartel in
question. As such, competition authorities will have no difficulty in relying on the established case law and the
general framework of Art. 101 TFEU to prove its case.
Conversely, a blockchain may in fact become a useful evidence for competition authorities to
strengthen its case. Blockchains’ immutability means that all information that is stored on the network, most
notably records about prices, sales, data collected by IOTs, and the cartel agreement which is embedded on
the blockchain via smart contracts, will be in theory permanently available in the network. Accordingly, when
competition authorities gain access to the blockchain network, a ledger which shows the entire history of the
cartel in question would be resurfaced. The recovered information will then be critical for the purpose of
assessing the scope of the agreement and its competitive outcomes
32 Ariel Ezrachi and Maurice Stucke, ‘Artifical Intelligence & Collusion: When Computers Inhibit Competition’ (2016) 2017(5) University of Illinois Law Review 1776, 1784 33 ibid. 1783
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CHAPTER THREE: CONCERTED PRACTICE
This Chapter primarily concerns information exchanges that take place in a blockchain network.
The Chapter will start by discussing the relationship between concerted practice and information exchange.
The next section explores how members of a blockchain network may share information and the type of
information that is typically shared. The last section analyzes information exchanges in blockchains context
under EU competition law.
Concerted Practice & Information Exchanges
Information exchanges can take place in different context. In general, there are three main
scenarios: (a) Information exchanges as part of an agreement, (b) information exchanges as part of a cartel,
and (c) pure information exchanges.34 An information exchange that is ancillary to an agreement or a cartel
will be assessed in the context of the agreement or cartel in question.35 As far as pure information exchanges
are concerned, such information sharing between undertakings is ‘stand-alone’ in the sense that it is not
dependent on a cartel or an agreement. The focus of this chapter will be pure information exchanges. From
the outset, it is important to note that the law in this area is rather controversial and thus there is no clear rules
for firms to adhere to.
Pure information exchanges are typically assessed as concerted practices under Art. 101 TFEU.
The term ‘concerted practice’ can be understood as a ‘catch-all’ provision that aims to capture undertakings
which seek to evade the application of Art. 101 TFEU by colluding in a way that fall short of an ‘agreement’.
The classic definition of ‘concerted practice’ can be found in Dyestuff,36 in which the Court held that it is “a
form of coordination between undertakings which, without having reached the stage where an agreement
properly so-called has been concluded, knowingly substitutes practical cooperation between them for the risks
of competition”.37 Far from requiring an actual plan to be worked out, the Court in Suiker Unie held that it
would be sufficient if there had been “any direct or indirect contact between operators, the object or effect
whereof is either to influence the conduct on the market of an actual or potential competitor or to disclose to
such a competitor the course of conduct which they themselves have decided to adopt or contemplate adopting
34 Organization for Economic Co-operation and Development, ‘Roundtable on Information Exchanges Between Competitors Under Competition Law’ (DAF/COMP/WD(2010)118 3 35 ibid. 36 Cases 48, 49, and 51–57/69, ICI v Commission [1972] ECR 619 [64] 37 ibid. [61]
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in the market”.38 As ‘concerted practice’ does not require an actual plan, it appears all that is required is the
existence of a “reciprocal cooperation or a joint intention to conduct themselves in a specific way, disclosed
through direct or indirect contact, designed to influence the conduct of an actual or potential competitor or to
reveal to them the course of conduct that will or may be adopted on the market”.39
As such, a reciprocal information exchange may constitute a mechanism for substituting
practical cooperation between the undertakings involved for the risks of competition. The concept of ‘reciprocal’
is however a broad one. In Cimenteries, it was held that the condition is met “where one competitor discloses
its future intentions or conduct on the market to another when the latter requests it or, at the very least
accepts”.40 As such, the concept of information exchange encompasses cases where undertakings have
discussed and communicated their future plans in the market, as well as cases where the conveyance of
information does not involve an express endorsement on the part of all the participants.41 The Court in Tate
& Lyle took this one step further by holding that the condition would be met even where “the participation of
one or more undertakings in meetings with an anticompetitive purpose is limited to the mere receipt of
information concerning the future conduct of their market competitors”.42 Stretching this decision further, it
would appear that the requirement would be satisfied even if an undertaking receives an unsolicited email or
fax from its competitors disclosing their future intention. Therefore, information sharing between undertakings
would be prohibited where it eliminates “the risks of competition and the hazards of competitors’ spontaneous
reactions”.43
Information Exchanges in Permissioned Blockchains
At its core, a blockchain is a distributed ledger. It is therefore natural for members of a
blockchain network to store information on it and share the stored information across the network. In
permissioned blockchains, only trusted nodes will be authorized to store copies of the blockchain. These nodes
38 Cases 40-48, 50, 54-56, 111, 113 & 114/73, Suiker Unie [1975] ECR 1663 [174]; The rationale behind this decision is that the notions of ‘coordination’ and ‘cooperation’ within the definition of ‘concerted practice’ must be understood in the light of a traditional concept that is inherent in EU competition law, that is each economic operator must determine the policy that it intends to adopt on the market in the future independently. 39 Alison Jones and Brenda Sufrin (n 13) 153 40 Cases T-25, 26, 30–32, 34–39, 42–46, 48, 50–71, 87, 88, 103, and 104/95, Cimenteries CBR v Commission [2000] ECR II-491 [1849] 41 Albertina Llorens, ‘Horizontal Agreements and Concerted Practices in EC Competition Law: Unlawful and Legitimate Contacts Between Competitors’ (2006) 51(4) The Antitrust Bulletin 837, 859 42 Case T-202/98, T-204/98 & T-207/98 Tate & Lyle plc v Commission [2001] ECR II-2035 [57] – [59] 43 ICI v Commission (n 31) [119]
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may or may not be the users of the blockchain network. Where a node is a user at the same time, it should be
able to see the stored information anytime it wants. Otherwise, where a user is not a trusted node, it would
have to access the blockchain through a node. In general, new information will be available as soon as the
block carrying the said information has been verified and added to the blockchain. In some permissioned
blockchains, such process could be dealt with within seconds.44 In other words, new information could be
available to all users of a blockchain network almost immediately after a new request is submitted to the
network.
However, it may also be argued that certain users could acquire new information even earlier.
As will be explained in more detail in Chapter Four, it is common to see permissioned blockchains feature a
‘leader’ whose responsibility is to propose blocks to be verified and added on the ledger. Similarly, such leader
may or may not be a user of the blockchain network. Where the leader is a user of the blockchain network at
the same time, he may acquire information as soon as when he is required to verify the proposed transaction.
It is argued that the idea that blockchains are encrypted may be a misleading thought. This is because, as
mentioned in Chapter One, parties that are responsible to certify transactions would require access to at least
a subset of information that is stored in the blocks so that they can cross-check the proposed blocks against
their records in order to verify the transactions. Therefore, it seems unlikely that users of a blockchain network
would encrypt the entire transaction before submitting a request on the network. As such, leaders may obtain
certain information during the transaction verification process and disclose it to other members of the
blockchain network. Alternatively, leaders may add comments, known as ‘noise’ in blockchains language, to
blocks during the verification process, although such comments are unlikely to be useful to others and are not
necessary for the blockchain to function.45 Nodes may then acquire certain information from these comments
when they are asked to confirm these blocks. It is argued that the presence of these two mechanisms allow
members of a blockchain network to gain information before the nodes have updated their local copies of the
ledger.
As mentioned, blockchain can be programmed to record virtually everything of value. Currently,
blockchains are mainly used by businesses to record economic transactions. This entails information such as
44 More details will be provided in Chapter Four. 45 Kiran Desai, ‘Blockchain and Competition Law’ (Law Alert, Ernst & Young LLP 2018) 2
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parties to the transaction, transaction history between the parties, payment, amount, etc. could be found within
a block and, depending on the degree of encryption configured by the parties, such information may be visible
to members of the blockchain network.46 Where however a smart contract is being placed on a blockchain, a
wider variety of information may be found in the blocks. In particular, parties to such a blockchain network
would store information regarding what has occurred, thereby triggering the automated process. As such, what
is actually contained in a blockchain depends on how it is being set-up and how the parties intend to use the
blockchain for.
EU Competition Law Application
Pure information exchanges in itself may be sufficient to establish a violation of Art. 101 TFEU
by object. In T-Mobile, it was held that an information exchanges is tainted with an anticompetitive object “if
the exchange is capable of removing uncertainties concerning the intended conduct of the participating
undertakings” and facilitating, directly or indirectly, the fixing of selling prices or any other trading conditions.47
In its Guidance Paper, the Commission summarized information that is capable of reducing certainty in the
market as ‘strategic data’, and such data includes information relating to prices, customer data, sales figures,
individual output.48 As such, where such information is stored on a blockchain, it seems that the very use of
this blockchain network is susceptible to antitrust scrutiny. In particular, competition authorities may deem the
sole purpose of setting up this blockchain network is to coordinate anticompetitive collusive behavior.
Where an information exchange is not found to have its object the restriction of competition, it
may still fall foul of EU competition law if the effect of such exchange is likely to have restrictive effects on the
market. In assessing whether the sharing of information may restrict competition by effect, the Commission
considered that the test is to compare the “likely effect of the information exchange with the competitive
situation that would prevail in the absence of the specific information exchange”.49 For this purpose, regards
will be given in relation to “the economic conditions on the relevant markets and the characteristics of
information exchanged”.50 As far as market characteristics is concerned, the Commission stated that certain
46https://www.blockchain.com/btc/block/0000000000000000062e8d7d9b7083ea45346d7f8c091164c313eeda2ce5db11 shows a Bitcoin blockchain. This provides an insight regarding that is typically stored in a blockchain. 47 Case C-8/08 T-Mobile [2009] ECR I-4529 [37], [43] 48 European Commission, ‘Guidelines on the Applicability of Article 101 of the Treaty of the Functioning of the European Union to Horizontal Co-operation Agreements’ (2011/C 11/01) 19 49 ibid. 16 50 ibid.
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market conditions would render it easier to sustain coordination. In particular, an information exchange will be
more likely to restrict competition in markets which are “sufficient transparent, concentrated, non-complex,
stable and symmetric”.51 As for the characteristics of information, the more strategic the information the more
likely the Commission will find the exchange restricts competition. In assessing the strategic nature of the
information involved, the Commission will consider factors such as age of the information, aggregation of the
information, market coverage, frequency of the exchange, and the venue where the exchange of information
took place.52
Applying the above to the blockchains context, it is argued that, even if strategic data is not exchanged,
where several competitors are found to be sharing the same blockchain network, it is highly suspicious in the
eyes of competition authorities. Concluding from the previous section, it seems that currently information that
is stored on blockchains primarily relates to firms’ past and current behavior. Although firms’ future intentions
are normally not found in a blockchain network, competition authorities may argue that the existing information
may nevertheless provide the firms a ‘focal point’ at which they can “reach a common understanding about the
terms of coordination”.53 Moreover, such information may also “facilitate stability of collusion by enabling
monitoring of deviations”.54 Accordingly, where the existence of parallel conduct between undertakings is
established, competition authorities may argue that such conduct is the result of coordination based on the
information exchanged on a blockchain network. In other words, blockchains may well become a ‘plus factor’
for competition authorities to conclude that the parallel conduct in question is the result of coordination.
Where a blockchain network is held to be a mechanism that facilitates coordination between
undertakings, whether it is by effect or by object, it is argued that the leader will be held liable as well even if
he is not a member of the cartel. EU competition law precludes any direct or indirect contact between
undertakings which aims at influencing each other’s conduct on the market. Therefore, any indirect exchange
of information between undertakings (the ‘spokes’) that take place through an intermediary (the ‘hub’) is also
prohibited. For example, in JJB Sports plc,55 it was held that a concerted practice in the context of ‘hub and
spoke’ arrangements may be established where (a) a retailer intended that the information be passed on by
51 ibid. 17 52 Para. 19 – 21 53 Organization for Economic Co-operation and Development (n 29) 2 – 3 54 ibid. 55 JJB Sports/ All Sports v Office of Fair Trading [2006] EWCA Civ 1318
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the supplier, (b) another retailer knew that the information had been provided by the first retailer, and (c) the
second retailer used that information in setting its conduct in the market.56 In the blockchains context, nodes
or users of a blockchain network will be regarded as the spokes, whereas the leader will be deemed as the
hub. Where a case of ‘hub and spoke’ arrangement is established, the hub may be held liable as well.57
However, there are two areas that competition authorities must pay attention to when proving the
existence of a concerted practice in the context of an online system, which arguably includes the blockchain
technology. Firstly, while the concept of ‘reciprocal’ is widely defined and clearly covers the sharing of
information in blockchains context, it nonetheless has limits. The case Eturas concerned an allegation of
coordination that was taken place via an online travel booking system used by more than 30 travel agents in
Lithuania.58 The Court was asked whether the fact that a message, which concerns the capping of the level
of online discounts which the travel agents should grant to customers, was sent via a personal electronic
mailbox on the online system is sufficient to establish that its addressees became or should have become
aware of its content and by fail to oppose the application of such a discount restriction they acquiesced in a
way that would be held liable for engaging in concerted practices.59 Central to this case was the contention
by the applicants who argued as they had not opened and read the message they could not be presumed to
have been aware of the message and so could not have engaged in a concerted practice. In its response, the
Court suggested that “infringements of competition law are subject to the presumption of innocence”. 60
Accordingly, where there is no evidence that the applicants have actually read the message, competition
authorities are precluded from inferring that they ought to have been aware of the content of the message
simply from the mere dispatch of the message. As such, it seems that one lesson can be learnt from this case
is that ‘actual awareness’ is one of the essential elements to demonstrate that an information exchange has
taken place. Applying this in the blockchains context, it is argued that, in order to show that parties to a
blockchain network have shared information, competition authorities must show the users have actually read
their local copies of the ledger. This is particularly true where a user could only access to the blockchain
through a node.
56 ibid. [91] 57 In Case AT. 39861 Yen Interest Rate Derivatives, the Commission sanctioned ICAP as one of its borker facilitate the cartel in question by serving as a conduit for collusive communications 58 Case C-74/14 Eturas UAB v Lietuvos Respublikos konkurencijos taryba EU:C:2016:42 59 ibid. 25 60 Ibid. 23
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Another area competition authorities must pay regards to is the line of case law relating to Business-
to-Business (B2B) e-marketpalces. B2B e-marketplaces are “software systems that allow industrial buyers and
sellers to transact business online over the Internet through a central node”.61 While B2B e-marketplaces
increase communication and transparency in the market, the flipside of the coin is that it is susceptible to being
exploited as a platform for exchanging strategic data between competitors. Nonetheless, the Commission
recognizes the pro-competitive effects of such marketplaces and has largely accepted that such platforms do
not infringe Art. 101 TFEU. For example, in Volbroker, the Commission cleared the creation of an electronic
brokerage service for trading foreign currency options after the founding firms gave several undertakings to
the Commission which aimed at “building ‘Chinese walls’ between the joint venture operating the exchange
and the parent companies which are active as market participants”.62 As such, it seems that the Commission
is in principle not against the use of e-marketplaces as long as the anticompetitive concerns had been dealt
with. Perhaps more guidance could be found in Covisint.63 After clearing the establishment of an automotive
e-marketplace, the Commission commented it is satisfied with the potential competition concerns had been
eliminated, particularly because the platform is “open to all firms in the industry on a non-discriminatory basis,
is based on open standards, allows both shareholders and other users to participate in other B2B exchanges
[…]”.64 It is argued that the Commission’s approach regarding e-marketplaces may to some extent reflect
where the law will stand in relation to blockchain networks. The blockchain technology largely produces the
same pro- and anti- competitive effects as B2B e-marketplaces do: On one hand, it enhances communication
and transparency, improves efficiency, and reduces costs. On the other, it may be exploited to facilitate
collusion. As such, it is believed information exchanges that is taken place in the context of blockchain networks
may not rise competition concerns as long as the Commission is satisfied that the anti-competitive concerns
have been eliminated, especially those as set out in Covisint.
61 Joachim Lücking, ‘B2B E-Marketplaces: A New Challenge to Existing Competition Law Rules?’ (Paper Presented at the Conference “Competition Law and the New Economy” at the University of Leicester 2001) 1 62 ibid. 7 63 Comp/38.064, IP/01/1155 Covisint Automotive Internet Marketplace 64 EU Commission, ‘Commission Clears the Creation of the Covisint Automotive Internet Marketplace’ (Comp/38.064, IP/01/1155 2001) <http://europa.eu/rapid/press-release_IP-01-1155_en.htm?locale=en> last accessed 14 August 2018
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CHAPTER 4: ANTICOMPETITIVE FORECLOSURE
In this Chapter, we will see how firms may collectively exclude a firm from participating in a
permissioned blockchain through the consensus protocols. The first part of this Chapter explores the notion of
‘consensus’. It will then be followed by a detailed explanation of consensus protocols. The final two section
discusses how firms could be excluded in a blockchain network and the applicability of EU competition in this
respect.
Consensus in Blockchains
Consensus is the heart of the blockchain technology. The notion of ‘consensus’ can be
understood as a state of agreement on which all or a majority of people agree. The lack of trust inherent in the
technology is particularly relevant to the notion. In a blockchain network, all authorized parties can propose a
transaction to be added to the ledger. While parties to permissioned blockchains are in theory more
collaborative, the possibility that some may betray their counterparts and disrupt the blockchain operation
cannot be precluded. It is therefore necessary for the nodes of a blockchain network to evaluate and agree on
the transactions before they are permanently incorporated into the blockchain. As such, the notion of
consensus plays a key role in determining whether the blocks store the ‘true version’ of a group of transactions.
Here, it is important to note that the concept of ‘truth’ as applied to blockchains does not refer to the traditional
understanding of the word. It merely means that the nodes are in agreement or consensus that the transaction
or event in question has happened. Accordingly, what has been agreed as valid by the nodes does not
necessarily mean that it has actually taken place. As long as an agreement is reached among the nodes, a
block could be appended to a blockchain. To some extent, this shows the process of adding blocks to a
blockchain “may be arbitrary or even controlled by an adversary”.65 In any case, the notion of consensus
enables multiple untrusted parties in a blockchain network to directly interact with each other without the
presence of a trusted intermediary. Achieving consensus in such a distributed system however is not an easy
task. For this purpose, a pre-agreed set of rules, known as ‘consensus protocols’ in blockchains language,
must be designed.
Consensus Protocol in Permissioned Blockchains
65 Shehar Bano and others, ‘SoK: Consensus in the Age of Blockchains’ (arXiv:1711.03936v2 [cs.CR], 2017) 4
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Currently, there are three main consensus protocols: (a) Proof-of-Work (POW), (b) Proof-of-
stake (POS), and (c) Practical Byzantine Fault Tolerance (PBFT). POW and POS are usually used in
permissionless blockchains, although it is also possible to employ these protocols in permissioned blockchains.
In general, POW and POS require miners to demonstrate some proof before proposing a valid block.66 Miners
in POW protocols must invest resources to find the answer to a computationally difficult puzzle, whereas for
POS they must show a ‘stake’ in the system, such as the number of coins held by the miner. Requiring miners
to ‘work’ in order to gain the right to propose new blocks means a high level of security is ensured as miners
who invest resources into updating the blockchain can be seen as a demonstration of good faith. However,
this would also result in a low transaction speed. For example, the Bitcoin protocol, which adopts POW, would
automatically adjust the difficulty of the puzzle.67 Currently, a new block can be added to the ledger only every
ten minutes.68 This is perhaps not ideal for businesses which prefer instant settlements.
It is more common to find permissioned blockchains employ PBFT protocols rather than POW
or POS. Derived from the Byzantine Generals’ Problem, PBFT is a solution for distributed computer networks
to operate as intended and correctly reach consensus despite the disruption of malicious or failing nodes.69
PBFT aims to mitigate the negative consequences of these dishonest participants have on the right consensus
that is reached by the honest parties. In blockchains context, PBFT protocols allow the signing of a block even
when 1/3 of the participants in the network fail or act maliciously.70 The flip side of the coin however is that,
for the protocol to work, the amount of dishonest nodes in the network cannot exceed 1/3 of the overall nodes
in the system at any point of time (the ‘assumption’). In general, instead of requiring miners to prove or
demonstrate something to gain the right of proposing blocks, PBFT protocols usually feature a predefined
validator (or ‘leader’) who is primarily responsible for such task. Accordingly, the leader would perform an initial
computation after it receives a message from blockchains users. It would then multicast the result to all other
nodes and ask them in turn to confirm whether the result is valid. The leader then awaits f + 1 (f = the number
of ‘dishonest’ nodes) replies from different nodes with the same result.71 Assuming the amount of malicious
nodes is less than 1/3 of the overall nodes in the blockchain network, this f + 1 replies should be the decision
66 Jean Bacon and others (n 10) 15 67 Satoshi Nakamoto, ‘Bitcoin: A Peer-to-Peer Electronic Cash System’ (2009) 3 68 Jean Bacon and others (n 10) 14 69 Miguel Castro and Barbara Liskov, ‘Practical Byzantine Fault Tolerance’ (Proceedings of the Third Symposium on Operating Systems Design and Implementation, 1999) 1 70 Christian Cachin and Marko Vukolić, ‘Blockchain Consensus Protocols in the Wild’ (IBM Research – Zurich, 2017) 6 71 Brian Curran, ‘What is Practical Byzantine Fault Tolerance? Complete Beginner’s Guide’ (Blockonomi, 11 May, 2018) <https://blockonomi.com/practical-byzantine-fault-tolerance/> last accessed 14 August 2018
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of the honest nodes. After confirming validation, the predetermined validator would then broadcast the decision
to the network, so that all nodes can update their local copies of the ledger. As such, comparing to POW and
POS protocols, it can be said that PBFT protocols are more centralized. This allows higher transaction speed
however scarifies the requirement of ‘trustless’ to some degree. Hence, it is not suitable for permissionless
blockchains which typically involve dynamic, large scale of unknown participants.
Moreover, PBFT’s centralized nature enables the blockchain to return to the traditional synchronous
protocols. In such protocols, nodes would “agree on a total ordering of the accepted blocks by adding agreed
blocks one at a time”.72 More specifically, they would “ensure every node has updated its copy of the
[blockchain] before moving on to the next block”.73 Contrasting with the asynchronous model typically used
by permissionless blockchains, the former is more capable of guaranteeing consistency between the copies
held by nodes.
Consensus is the backbone of a blockchain. As such, consensus protocols, which manifest how
members of a given blockchain intend to reach consensus, is capable of shaping the characteristics of the
blockchain. Permissioned blockchains normally employ PBFT protocols and synchronous protocol. This then
explains the common features of such blockchain model, which typically include: (a) few number of participants,
(b) static number of participants, (c) operated by known entities, and (d) a level of trust exists among the
participants.
Foreclosure in Permissioned Blockchains
It is argued that the use of PBFT protocols may lead to foreclosure risk, which may be
manifested in two forms: (a) Access refusal, and (b) prioritization.
It is likely that access to a permissioned blockchain will be restricted by members of the
blockchain consortia in question. PBFT protocols perform better when there are few nodes and they are known
to each other due to their centralized nature. Similarly, synchronous protocols work where there is only a
limited number of nodes.74 As such, members of a blockchain network that adopts such protocols would want
72 Jean Bacon and others (n 10) 13 73 ibid. 74 Some suggested that a few tens of nodes is the maximum; Jean Bacon and others (n 10) 13
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to set up the blockchain in a way that only authorized parties can join and participate in the network. In
competition law language, such access control by existing members of the blockchain consortia is known as
gating, and in certain circumstances such conduct may fall foul of EU competition law.
Even if a firm is given authorization to join the network, original members may engage in some
conducts such that the firm is effectively being precluded from using the technology. For example, they may
configure the blockchain so that the new entrant only has limited permission to store the blockchain and add
new blocks. Moreover, since PBFT protocols require merely 2/3 members come to an agreement for the
purpose of signing new blocks instead of demanding a unanimous consensus, it would also be possible that a
firm’s proposed transactions are all rejected by other members without objective cause. As such, while a firm
may be granted access to the blockchain network, original members of the network may still constructively
refuse certain parties, thereby preventing them from participating in the blockchain network meaningfully. To
some extent, these conducts can also be seen as collective boycott.
Foreclosure in permissioned blockchains may also take the form of prioritization. In essence,
prioritization can be understood as certain members’ transactions are given precedence over the others. The
issue of ‘prioritization’ in blockchains, in some way, resembles the net neutrality debate. The EU described net
neutrality as “a non-discrimination principle, requiring that all electronic communication passing through an
internet service provider (ISP) network is treated equally”.75 In other words, without net neutrality, ISPs would
be free to offer varying levels of connectivity to content providers at different price range. Naturally, a multi-
tiered Internet system may emerge, and this would create competition concerns. For example, start-ups that
could not afford for the ‘best connection’ service would have to resort to the ‘standard connection’ which in turn
may lead to poorer accessibility and speed of access to its products.
Similarly, ‘prioritization’ in a blockchain would create at least a two-tiered system, whereby certain
members’ transactions would be dealt with more efficiently. In PBFT protocols, it is necessary for a
predetermined validator or leader to first verify the proposed transaction before broadcasting the results to
other nodes for confirmation. When working in conjunction with the synchronous protocol, this would mean
75 Tambiama Madiega, ‘The EU Rules on Network Neutrality: Key Provisions, Remaining Concerns’ (European Parliament Research Service 2015) 1
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that transactions can only be verified one at a time in order to ensure new blocks would be added to the
blockchain in the same logic. As a result, a ‘queue’ for transactions verification would be formed. Depending
on the precise set-up of the blockchain, the leader may be given discretion in determining whether any of such
transactions should be given priority. It would then be possible that the leader may work in an unfair or bias
way, for example favors corporate affiliations over the others, so that the clearance of transactions of certain
members would always go first. Alternatively, certain members of the blockchain network may collude with the
leader in order to ensure their transactions are given preferences over the others. In any event, distinguished
from the collective boycott situation as discussed in Chapter Two, all transactions in this case would be verified,
although some may be processed later than the others. Consequently, members whose transactions are
inferior to the others would feel that they are being placed at a competitive disadvantage position.
EU Competition Law Application
Traditionally, anticompetitive foreclosure is dealt with by Art. 102 TFEU. However, it is argued
that the provision may be ineffective in blockchains context. Competition authorities must therefore seek
alternate recourses.
It is clear that the Commission intended to prohibit anticompetitive foreclosures by Art. 102
TFEU.76 In its Guidance Paper, the Commission described foreclosure as “a situation where effective access
of actual or potential competitors to supplies or markets is hampered or eliminated as a result of the conduct
of the dominant undertaking”. 77 Importantly, EU competition law targets not just ‘foreclosure’ but
‘anticompetitive foreclosure’, thus it requires such exclusion of competitors to have “an adverse impact on
consumer welfare”. 78 Considering the wordings used by the Commission, in particular ‘dominant’ and
‘conduct’, it can be said that the definition fits more comfortably with Art. 102 TFEU, which was designed to
prohibit unilateral abusive conduct of undertakings in a dominant position. Therefore, for the purpose of
establishing anticompetitive foreclosures under Art. 102 TFEU, two elements are crucial: (a) Abuse, which in
this case would be the anticompetitive foreclosure, and (b) a dominant position. However, it may be
problematic to demonstrate the element of ‘abuse’ in the blockchains context.
76 Article 102 of the Treaty on the Functioning of the European Union 77 European Commission, ‘Guidance on the Commission’s Enforcement Priorities in Applying Art. 82 of the EC Treaty to Abusive Exclusionary Conduct by Dominant Undertakings’ (2009/C 45/02) [19] 78 ibid.
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Abuse
The conducts identified in the previous section can be analyzed under a line of EU case law
known as “refusal to supply”. In general, where a dominant undertaking refuse to supply its products or services
or grant access to its facilities it may infringe Art. 102 TFEU. Moreover, the notion of refusal to supply includes
constructive refusals, i.e. where the supply, known to the supplier, is unacceptable or unduly delayed.79
Although EU competition law does not impose a duty to dominant undertakings requiring them to supply
products or services to whoever requests them to do so, in certain situations a refusal to supply constitutes an
‘abuse’. Of relevance here is the situation of ‘essential facility’ doctrine.
At its simplest, the concept of ‘essential facility’ denotes the situation where a competitor need access
to something that is owned or controlled by a dominant undertaking such that the former can provide products
or services to its customers. In B&I/Sealink,80 the very first case that saw the expression ‘essential facility’
being used, the Commission, after defining ‘essential facility’ as “a facility or infrastructure without access to
which competitors cannot provide services to their customers”,81 stated that where a dominant undertaking
refuses its competitors access to such facility or grants access to them only on less favourable terms “thereby
placing the competitors at a competitive disadvantage” infringes Art. 102 TFEU.82 The principle was then
applied in several subsequent cases decided by the Commission. It is argued that, with hindsight, the doctrine
was in fact used in even earlier cases. For example, the Commission in London European/ Sabena decided
that Sabena’s refusal to grant London European access to its Saphir system, an online system which
“streamlined the procedure of travel agents to consult flight schedules, fares and seat availability of airlines
included in the system, and to make reservations”, constitutes an abuse of its dominant position in the relevant
market.83 To some extent, the online system in this case is similar to a blockchain network in the sense they
are both ‘online platforms’ in the broadest sense. Thus, it can be argued that the Commission would have no
difficulty in concluding a blockchain network is an ‘infrastructure’ for the purpose of satisfying the ‘essential
facility’ test.
79 Napier Brown/ British Sugar [1998] OJ L284/41 80 IV/34.174, Sealink/B&I Holyhead: Interim Measures 11 June 1992 81 ibid. [41] 82 ibid. 83 London-European/ Sabena [1988] OJ L317/47
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The ‘essential facility’ doctrine represents a powerful intrusive measure for competition authorities
such that it can force dominant undertakings to share its valuable assets or resources where necessary.
Unsurprisingly, as it may severely interfere an undertaking’s rights, the Court halted the expansion of the
doctrine. In Bronner, the Court held that access to a facility would be ordered only in very limited
circumstances.84 In particular, such order would only be permitted where the refusal is likely to “eliminate all
competition” in the market on the part of the person requesting the service or product and that the access must
be “indispensable to carry on that person’s business, inasmuch as there is no actual or potential substitute in
existence” for it.85 As such, Bronner sets a high hurdle for invoking the ‘essential facility’ doctrine: the refusal
has to be likely to ‘eliminate all competition’, but not merely leading it ‘more challenging’ to compete; the access
must be ‘indispensable’, but not merely ‘desirable’.
While a blockchain could be regarded as a ‘facility’ for the purpose of ‘essential facility’, it is argued it
would be difficult to invoke the doctrine as a whole in the blockchains context. The following example may
provide an illustration. Several European banks, including one major bank, form a blockchain consortia for the
purpose of facilitating interbank payments. The traditional way of clearing interbank payments remains
available, although in comparison it would be much slower and costly. Accordingly, being a member of the
blockchain consortia may be necessary if a bank wants to be competitive in the market in question. Where it
is being refused access to the blockchain, it appears this constitute an abuse. Here, the blockchain seemingly
represents an important facility without access to which the bank may not be able to effectively provide services
to its clients. However, according to Bronner, the ‘essential facility’ test is in fact not satisfied. Having access
to the blockchain is merely desirable for the bank but not indispensable as the traditional way of settling
payments is still available. The fact that the traditional way is much slower and costly does not mean that all
competition has been eliminated. On the contrary, it is just more difficult for the bank to compete with its rivals.
As such, it is argued that it would be a daunting task for competition authorities to prove a blockchain is an
‘essential facility’.
Similar conclusion can be made in relation to the issue of ‘prioritization’. The problem of ‘prioritization’
is also a case of a refusal to supply in the sense that the blockchain is set up in a way that some of its member
84 Case C-7/97 Oscar Bronner GmbH & Co KG v Mediaprint [1998] ECR I-7791 85 ibid. [41]
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is denied having access to prioritized services. Slightly different from the scenario of ‘access refusal’ as
discussed above, what is at stake here is the ability to have access to prioritized services. Nonetheless,
Bronner remain to be applicable: prioritization is not indispensable as there is an alternative method being
available, namely non-prioritized transaction verification; the presence and availability of non-prioritized
transaction verification means that competition is not eliminated in its entirety. Accordingly, it is almost certain
that, under the current law, dominant undertakings are not prohibited from providing prioritized services.
Collective abuse
Even if the element of ‘abuse’ is seemingly established, it may not amount to an abuse of a collective
dominant position. It is settled law that ‘one or more undertakings’ in Art. 102 TFEU can refer to economically
independent undertakings which together hold a ‘collective dominant position’ in the market, provided that they
are “united by […] economic links”.86 The notion of ‘economic links’ must be understood broadly such that
“from an economic point of view they present themselves or act together on a particular market as a collective
entity”.87 In other words, the form of ‘collaboration’ between such undertakings is irrelevant. Rather, as long
as they hold themselves out as a collective entity and act together independently of their competitors, the
requirement of ‘collective dominance’ will be satisfied. Given this broad view of the links required to establish
a finding of collective dominance, it is argued that the presence of undertakings within the same blockchain
network may represent as a plus factor for competition authorities to demonstrate that a collective entity indeed
exists. The question is then whether this collective entity holds a dominant position. If this is answered in
affirmative, then it would be necessary to consider whether the requirement of ‘collective abuse’ is satisfied.
Central to the issue of anticompetitive foreclosure in the context of blockchains is that the exclusion is
conducted by multiple parties collectively, yet the case law on what amount to abuse by collective dominant
entities is underdeveloped. For example, in TACA the Court simply held that, on the facts, the Commission
failed to demonstrate that the undertakings could induce potential competitors wishing to enter the market to
join the TACA by the measures in question without further explaining the legal rationale behind.88 It is
therefore uncertain whether a collective decision refusing to supply an undertaking in general would be
86 Cases T-68, 77, and 78/89, Società Italiano Vetro SpA v Commission [1992] ECR II-1403 [357] 87 Joined cases C-395 and C-396/96P, Compagnie Maritime Belge Transports SA and others v. Commission (‘Cewal’), [2000] ECR I- 1365 [36] 88 Cases T-191 and 2120214/98 Atlantic Container Line v Commission [2003] ECR II-3275
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deemed as an abuse of collective dominance. Where however the ‘essential facility’ doctrine is successfully
invoked, it is possible that refusing to grant access to a blockchain network could amount to abuse. This is
because in such scenario, given all competition has been eliminated, it is arguable that the exclusionary
conduct engaged by the firms would “hinder the maintenance of the degree of competition existing in the
market or growth of that competition”, thereby strengthening the collective dominant position.89 However, as
mentioned, it would not be an easy task to invoke the doctrine. Accordingly, it seems questionable whether
the concept of abuse, which has been primarily developed in the context of individual dominant firm, is the
ideal mechanism for the propose of prohibiting practices that may facilitate or stabilize a collusive strategy
engaged by several undertakings in the market.
In any case, it seems difficult to explain a collective decision to refuse to supply to an undertaking
without considering the element of collusive behavior. For example in both Compagnie Maritime Blege and
TACA the Commission had found that the parties did engage in some liner conferences before embarking the
alleged abusive conducts. Moreover, in proving these cases, the Commission in essence simply recycled the
facts of the Art. 101 infringement to demonstrate a violation of Art. 102 TFEU. As such, it is argued that, to a
large extent, cases that involve collective abuse overlaps with Art. 101 TFEU. Against this backdrop, it
therefore appears that Art. 101 TFEU may be more relevant when it comes to anticompetitive conducts in
blockchains context. Indeed, in Chapter Two, the paper showed that the notion of ‘agreement’ in fact capable
of encompassing far more context, including unilateral conduct by one firm to another; in Chapter Three, the
paper stated that the notion of ‘concerted practice’ must be understood broadly, in particular it seems the only
way for firms to escape being scrutinized by competition authorities under the application of concerted practice
is to demonstrate that they had decided their future conducts in the market independently. Accordingly, these
broad and liberal definitions allow competition authorities to apply Art. 101 TFEU to capture all sort of loosely
formalized forms of cooperation. It is therefore argued that Art. 101 TFEU is perhaps the better venue to prove
anticompetitive foreclosures in permissioned blockchains.
89 C-209/10 Post Danmark I EU:C:2012:172 [24]
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FURTHER RESEARCH
Before moving on to the conclusion, this paper would like to highlight its limitation and
recommend an area for further research.
This paper has primarily focused on the ex post regulation of blockchain networks. Indeed,
competition law is typically regarded as an ex post market regulation tool in that competition authorities react
only after the emergence of anticompetitive practices. In blockchains context, as can be seen, Art. 101 and
potentially Art. 102 TFEU would be invoked after the formation of blockchain network and after anticompetitive
conducts are observed. The question is then whether competition authorities would regulate these networks
prior to their establishment?
Beyond Art. 101 and 102 TFEU, European Merger Control Regulation (EUMR) may be deemed by
the regulators as a useful tool to regulate blockchains network ex ante. In general, the current EUMR prohibits
‘concentrations’ with an EU dimension that would impede effective competition in the internal market or a
substantial part of it. In other words, the purpose of EUMR is to prevent changes in market structure that would
have a negative impact on the competition landscape in the internal market. As far as the notion of
‘concentration’ is concerned, it has been widely defined in order to cover mergers, acquisitions of control, and
the creation of full-function joint ventures.90 Of relevance for the blockchains context is the last point – joint
ventures. Art. 3(4) EUMR provides that a joint venture will give rise to a concentration where the following
conditions are met: (a) its parent companies reserve joint control on the joint venture, (b) lack of autonomy in
the joint venture, and (c) the joint venture is not intended to operate on a lasting basis.91 As mentioned in the
introduction, firms, including market leaders, are now working together for the purpose of developing the
blockchain technology for commercial applications. Some blockchain consortium, such as the Digital Trade
Chain, have even emerged into joint ventures that operate in the reality. As such, where the joint venture is in
essence a sham for the firms to strengthen their dominant positions in the market, it may appear that the EUMR
may be applicable in blockchains context, enabling competition authorities to adopt pre-emptive measures on
blockchain networks.
90 Article 3(1) and (4) European Merger Control Regulation 91 Article 3(4) European Merger Control Regulation
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However, the application of EUMR in blockchains context may not be as straightforward as first
thought. Art. 2(3) EUMR requires that competition authorities to demonstrate that the concentration would
“significantly impede effective competition in the common market or in a substantial part of it, in particular as
a result of the creation or strengthening of a dominant position”.92 This then entails that competition authorities
must make an assessment in the market in question, in particular it must decide what the market in question
is and the market power of the firms is involved. Similar assessment has to be done under Art. 102 TFEU and
it has been proven that this may be a tricky task. The question is then whether the fact that blockchain
technology is employed would make this assessment easier or even more difficult. As such, there are a number
of gaps in our knowledge around blockchain and merger control and thus it is believed that further research
focusing on this area would be beneficial.
92 Article 2(3) European Merger Control Regulation
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CONCLUSION
This paper has examined how firms may exploit the architecture of blockchains such that it
becomes possible for them to participate in certain collusive behavior. Two features of the technology are
particularly relevant. Firstly, blockchain as a distributed ledger. Secondly, blockchains’ consensus protocols,
in particular the PBFT protocol.
In Chapter Two, the implication of the blockchain technology on explicit collusion is discussed.
It is suggested that the technology, along with Smart Contracts and Internet of Things, may offer an efficient
way to enforce an explicit agreement with an anticompetitive intention, for example cartel agreements. Outside
the context of cartels, the paper considered that firms may agree to boycott their competitors collectively via
the consensus protocols so that the affected undertakings could not participate in the blockchain network
meaningfully. It is argued that these issues should not pose any difficulty for competition authorities that are
seeking to prohibit such conducts through EU competition law as parties to these agreements remain to be
the main actors and the blockchains are merely tools for these parties to facilitate their agreements.
In Chapter Three, the paper discussed how firms may share information between themselves
on a blockchain. Central here is blockchains’ core functionality: distributed ledger. Accordingly, in blockchains,
information is exchanged simply when firms store records on the blockchain as these records will be replicated
and shared automatically among all members once being put on the network. Under EU competition law,
information exchanges are usually assessed as concerted practice as, according to one of the inherent
competition principles in EU law, firms must formulate their future conduct in the market independently. It is
recognized that the law is this area is not settled and currently there is no bright-line rule for reference. As
such, while it is argued that EU competition law is largely applicable to the situation, competition authorities,
or professional advisors, may need to take two lines of case law into account, namely the requirement of
‘awareness’ in relation to information available on various online platforms and B2B e-marketplaces.
Chapter Four focuses on anticompetitive foreclosure. The paper suggested that the notion of
‘consensus’ is the heart of the blockchain technology, and the way how the firms intended to reach
consensuses will be codified into a consensus protocol. In most permissioned blockchains, the protocol that is
being commonly used is known as the PBFT protocol, which is a protocol that allows firm to tolerate 1/3
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indifferent results. This could be deemed as a loophole such that firms could exploit it to exclude certain
members in blockchain network. Traditionally, under EU competition law, anticompetitive foreclosure is a topic
that is assessed under Art. 102 TFEU, which is a provision that has been primarily developed to sanction
unilateral conducts performed by individual dominant firms. It is therefore argued that Art. 102 TFEU could not
comfortably deal with antitrust issues that arise from permissioned blockchains, a technology that emphasize
the notion of ‘shared control’. However, collective abuses are inherently creatures of collusive behaviors.
Accordingly, this entails that Art. 101 TFEU should be available for tackling the issue of anticompetitive
foreclosures, despite this is a topic that is typically assessed under Art. 102 TFEU.
Immediately before this conclusion, this paper has suggested that further research in relation
to the relationship between blockchains and competition law can be made in the area of merger control. As
firms have acquired more understanding regarding the blockchain technology, it is increasingly popular for
firms to form joint venture to put the concept into reality. It therefore appears that there is an imminent need
for competition authorities to investigate the applicability of EUMR on blockchains.
Overall, EU competition law, in particular Art. 101 and 102 TFEU, is applicable to blockchains
uses. As such, when firms, especially competitors, are sharing a blockchain infrastructure, they must be
mindful of the implication of the antitrust rules in this regard. In particular, firms must be careful of what
information they are sharing with the other firms and they must not engage in conducts such that other
members in the blockchain network are prevented from using the facility.
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DLTs in current EU financial market infrastructures:
restricted or unrestricted network?
A legal perspective
Salvatore Pantaleo
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Table of Contents
ABSTRACT ..................................................................................................................................................... 60
INTRODUCTION ............................................................................................................................................. 60
1 RELEVANT CONCEPTS OF BLOCKCHAIN TECHNOLOGY AND ITS ATTRACTIVENESS TO FINANCIAL MARKETS. .................................................................................................................................. 62
1.1 INTRODUCTION ................................................................................................................................... 62 1.2 BLOCKCHAIN. ..................................................................................................................................... 62 1.3 UNRESTRICTED LEDGER ..................................................................................................................... 63 1.4 RESTRICTED LEDGER ......................................................................................................................... 64 1.5 SMART CONTRACT.............................................................................................................................. 64 1.6 DISTRIBUTED LEDGER ........................................................................................................................ 65
2 WHY IS BLOCKCHAIN ATTRACTIVE TO FINANCIAL MARKETS? ................................................... 65
2.1 INTRODUCTION ................................................................................................................................... 65 2.2 IMMUTABILITY ..................................................................................................................................... 67 2.3 TRUSTLESSNESS ................................................................................................................................ 68 2.4 TRANSPARENCY ................................................................................................................................. 69 2.5 AUTOMATION ..................................................................................................................................... 70 2.6 RESILIENCE ....................................................................................................................................... 72
3 FMIS: RESTRICTED OR UNRESTRICTED DLT? ................................................................................. 73
3.1 INTRODUCTION ................................................................................................................................... 73 3.2 BRIEF HISTORICAL EVOLUTION OF CENTRALISATION IN FMIS ................................................................. 74 3.3 REGULATORY FRAMEWORK: PFMI AND EU REGULATION ...................................................................... 77 3.4 WHY IS AN UNRESTRICTED DLT NOT SUITABLE FOR FMIS? A GOVERNANCE ISSUE. ............................... 80 3.5 WHY IS A RESTRICTED DLT SUITABLE FOR FMIS? ................................................................................ 84
4 A CASE STUDY ON CENTRAL SECURITIES DEPOSITORY ............................................................. 86
4.1 INTRODUCTION .................................................................................................................................. 86 4.2 DLTS AND CSDS’ NOTARY FUNCTION AND RECONCILIATION PROCEDURE .............................................. 87
5 CHALLENGES ........................................................................................................................................ 88
5.1 INTRODUCTION ................................................................................................................................... 89 5.2 HARMONISATION OF THE ISSUANCE PROCESS ...................................................................................... 89 5.3 SSS AND PAYMENT SYSTEMS INTEROPERABILITY IN DVP ..................................................................... 89 5.4 FMIS AND EXTERNAL SYSTEMS INTEROPERABILITY ............................................................................... 90 5.5 SETTLEMENT FINALITY IN INSOLVENCY PROCEEDINGS .......................................................................... 90 5.6 NATURE OF THE ASSET IN DLTS AND COLLATERAL MANAGEMENT ......................................................... 91
CONCLUSIONS .............................................................................................................................................. 91
LIST OF ABBREVIATIONS ............................................................................................................................ 93
BIBLIOGRAPHY ............................................................................................................................................. 95
Abstract
The purpose of this study is to show that European financial market infrastructures should opt for restricted distributed ledger technologies when considering a potential implementation of this new technology to reduce both costs and risks over financial transactions. The idea of technology that can eliminate financial intermediaries is debunked by careful historical and technical analysis in relation to operational risk management, formal governance, and the underlying regulatory framework consisting of both international standards and EU legislation. An example, in support of this analysis, is given about the potential use of restricted DLTs by a central securities depository that has to carry out its notary function and reconciliation procedures in order to ensure the integrity of the issue of securities. The result is the complete exclusion of unrestricted DLTs in favour of the restricted ones. However, certain challenges remain to be solved before a large-scale implementation of such a technology may occur.
Introduction
Starting from 2009 with the debut of Bitcoin, different types of distributed ledger technology (DLT) have spread
in the market providing different models that could be used in different financial and non-financial fields.
Although Bitcoin is a technology that was invented to deploy a peer-to-peer version of electronic cash, starting
from 2015, DLTs have been considered as a new technology that may revolutionise current financial market
infrastructures (FMIs)93 in the name of greater efficiency and higher security with the final objective of removing
the so-called financial intermediaries.
Such a technology came up with features like immutability, transparency, automation, and resilience that
appeared to be attractive to financial markets. Advocates of this technology, who base their analysis on these
characteristics, argue that this innovation will eliminate current financial intermediaries in favour of direct trade
between seller and buyer. However, each of those features requires a trade-off in order to meet current
regulatory constraints which are the result of a historical process that has led to increasingly efficient risk
management. Saying this does not imply that DLTs cannot be implemented in FMIs. In fact, major financial
institutions, central banks, and consultancy firms have published many reports on the subject highlighting the
potential of this new technology together with correlated challenges. What emerges from these publications is
an inclination towards the implementation of restricted DLTs in FMIs instead of the unrestricted ones.
The European Securities and Markets Authority (ESMA) “stresses that entities or groups of entities willing to
use the DLT should be mindful of the existing regulatory framework. In addition, they should be mindful of a
number of principles, which underpin the current market infrastructures, in particular, the CPMI-IOSCO
Principles for Financial Market Infrastructures (PFMIs).”94 Not doing so would bring to a replacement of the
93 Components of FMIs are: Systemically Important Payment Systems (SIPS), Central Securities Depositories (CSDs), Securities Settlement Systems (SSSs), Central Counterparties (CCPs), and Trade Repositories (TRs). 94 ESMA, 'Discussion Paper - The Distributed Ledger Technology Applied To Securities Markets' (2016) s 2.2, para 7 <https://www.esma.europa.eu/press-news/esma-news/esma-assesses-usefulness-distributed-ledger-technologies> accessed 11 August
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current set up of FMIs with new risks that should be addressed by a completely new regulatory framework.
Something that is unlikely to be undertaken by the regulators at this early stage. For these reasons, DLTs
should be seen as a technology capable of improving internal processes of already existing FMIs. However,
this will only be possible after overcoming some regulatory and operational challenges.
Section 1 provides a concise background to the analysis covered by the rest of the study highlighting and
explaining the relevant technical terminology involved in DLTs. Section 2 examines five main features of DLTs
that make this technology attractive to financial markets together with regulations that require a trade-off of
these characteristics for compliance reasons. This section also provides suggestions regarding a potential
regulation of DLT systems by comparing the automation features of DLTs with the regulatory provisions
concerning the algorithmic trading in EU. Section 3 starts by analysing the rationale of FMIs with a brief
historical study that explains the natural process of centralisation and the importance of CCP in risk
management. This study is essential to better understand the following regulatory framework regarding the
FMIs’ governance arrangements and operational risk management. Such regulations force FMIs to opt for a
restricted DLT system instead of an unrestricted one. Section 4 is an example of how a restricted DLT can be
used by a CSD to carry out its notary function and reconciliation procedures under CSD Regulation (CSDR).95
Although the use of a restricted DLT system complies with most of CSDR, some amendment of ESMA’s
regulatory technical standards (RTS) on reconciliation procedures are required. This section provides
suggestions in this regard. Section 5 examines five challenges both at the regulatory level and operational
level that have to be faced before FMIs can implement DLTs in large scale. These challenges are: i) the need
of harmonisation of the securities issuance process at national level; ii) the lack of interoperability between
SSS and payment systems in delivery versus payment (DvP) procedures; iii) the lack of interoperability
between FMIs’ DLTs and other external participants’ systems; iv) the incompatibility of DLTs with the
Settlement Finality Directive (SFD)96 in relation to the opening of insolvency proceedings against participants;
and v) the nature of the asset registered on a DLT in relation to collateral management. The last part of the
2018; CPSS-IOSCO, 'Principles For Financial Market Infrastructures' (2012) <https://www.bis.org/cpmi/publ/d101.htm> accessed 18 July 2018 (CPSS-IOSCO, PFMIs). 95 Regulation (EU) No 909/2014 of the European Parliament and of the Council of 23 July 2014 on improving securities settlement in the European Union and on central securities depositories and amending Directives 98/26/EC and 2014/65/EU and Regulation (EU) No 236/2012 [2014] OJ L257/1. 96 Directive 98/26/EC of the European Parliament and of the Council of 19 May 1998 on settlement finality in payment and securities settlement systems [1998] OJ L 166/45 as amended (SFD).
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study draws conclusions, from the analysis in the previous sections, on the potential implementation of
restricted DLTs in EU FMIs instead of unrestricted ones.
1 Relevant concepts of blockchain technology and its attractiveness to financial markets.
1.1 Introduction
In discussing what blockchain architecture is the most suitable to the evolution of current EU FMIs in correlation
with the UE legal framework, it is necessary to understand the current landscape of this technology. The
terminology used in this field is still evolving, and terms like distributed ledgers, blockchain, shared ledgers are
used interchangeably. Given the lack of legal or formal definitions, this section defines the key concepts that
are useful to understand the potential implementation of blockchain in FMIs. Technical terminology is indicated
in Italic the first time it appears in the text.
1.2 Blockchain.
As mentioned above, there is no specific legal definition of blockchain. However, a link with the law can be
found within the “Directive on the legal protection of databases” that defines, in broad terms, a database.97
Pursuant to Article 1(2), a database is “a collection of independent works, data or other materials arranged in
a systematic or methodical way and individually accessible by electronic or other means.”98 A blockchain is, in
fact, a type of shared database or ledger that collect a specific amount of transactions (data) into blocks rather
than recording them one after the other in a continuous ledger. The ledger runs on a distributed peer-to-peer
network on the top of the internet.99 This network is composed of independent nodes (computers or servers)
that perform various functions depending on the role they take.100 Every block is composed by a predefined
number of transactions that represent the fundamental unit of a blockchain. Each transaction is stored within
97 Directive 96/9/EC of the European Parliament and of the Council of 11 March 1996 on the legal protection of databases [1996] OJ L77/20. 98 Ibid art 1 (2). 99 Imran Bashir, Mastering Blockchain: Deeper Insights Into Decentralization, Cryptography, Bitcoin, And Popular Blockchain Frameworks (Packt Publishing 2017) 17. 100 ibid 21.
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an address, a unique identifier on the blockchain that denotes the sender and the recipient of the transaction,101
and represents a value or an asset that has been tokenised through an encryption algorithm (hash function)
and validated by one or more nodes (validators).
Moreover, to further corroborate the truth of the ledger, every block, except the first block (genesis block),102
is cryptographically linked with the previous one with a hash pointer. The latter is created through a validation
protocol of the previous block carried out by a validator on the network by running a consensus protocol (or
algorithm) that is tailored to the type of blockchain.103 If everyone can participate in this process, the blockchain
is called unrestricted. If participants are preselected, the ledger is called restricted. The data structure, as
described above, together with cryptographic algorithms allow blockchain to be used as a ledger that is, at
least in theory, more resilient, secure, transparent, and censorship-resistant than a typical database. However,
the qualitative aspect of each characteristic depends on the way the technology is structured.
1.3 Unrestricted ledger
An unrestricted (also called public or permissionless) ledger is a database in which everybody can participate
by making legitimate changes, reading, adding and validating transactions or blocks (as long as he or she
follows the rules). Every node has an identical copy of the ledger (decentralisation), and a validator can walk
away from the network and come back in every moment without disrupting the ledger. The other participants
(nodes) “maintain the integrity of the ledger by reaching a consensus about its state.”104 The best example is
Bitcoin’s blockchain.
101 ibid 19. 102 A genesis block is the first block of a blockchain. 103 The type of consensus mechanism in a blockchain is fundamental in terms of scalability of the system: the ability of the network to handle a significant amount of transaction at a certain point in time or to be potentially enlarged to face growth in the number of transactions. An FMI requires high performances in this sense, and they cannot be achieved with a consensus algorithm that is slow in validating transactions. Proof of work (PoW) used in Bitcoin’s architecture is one of them. For a short guide regarding consensus algorithm, see Bashir (n 99) 28-30. 104 David Lee and Robert Deng (eds), Handbook Of Blockchain, Digital Finance, And Inclusion. Chinatech, Mobile Security, And Distributed Ledger, vol 2 (Academic Press 2017) sub-s 12.3.
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A public blockchain is, in theory, decentralised also in terms of software governance, a crucial aspect for the
purpose of this paper.105 For now, it is important to understand that every software needs to be updated, fixed,
and improved with new features by software developers and that the software governance deals with this issue.
1.4 Restricted ledger
A restricted (also called private or permissioned) ledger is not open to everyone so that participation is
restricted to identified entities. The ledger’s integrity is ensured by trusted nodes (for instance, banks or
government departments) and the network is owned by one, some or all of them. The owners usually oversight
the whole system. There are two kinds of restricted ledgers: (i) a restricted egalitarian ledger where all users
can play any role; and (ii) a restricted tiered ledger where the owner(s) chooses the validators and decide the
role of any participant together with their degree of access to information stored within the ledger. These
structures are considered less censorship resistant but faster in terms of scalability than a public blockchain.
Moreover, the software is governed by a formal type of governance that can help to solve some of the major
problems of a public blockchain in relation to FMIs.106
1.5 Smart contract
Another difference with regular databases is that the blockchain can set rules about a transaction allowing the
creation of self-enforcing contracts that will modify the blockchain’s data (business logic).107 The latter can be
done through smart contracts, programs that “run on the top of the blockchain and encapsulate the business
logic to be executed when certain conditions are met.”108 There are different interpretations of the concept of
smart contracts. However, for this paper, I will take into consideration the definition of “smart legal contract” of
105 A blockchain can include on-chain voting mechanisms that formalise the governance transforming it into a democracy where every participant can vote to decide the sort of the network. With this arrangement, the software governance remains decentralised. If this is not the case and the network is based on open-source code, then the software governance tends to be technocratic so that a few stakeholders control the core’s development roadmap. However, if other stakeholders disagree with technocratic rulers, they can “revolt” by creating a new project based on the old one (fork). See Taylor Pearson, 'The Downside Of Democracy (And What It Means For Blockchain Governance)' (CoinDesk, 2018) <https://www.coindesk.com/downside-democracy-means-blockchain-governance/> accessed 8 July 2018. See also sub-ss 2.3, 3.3, 3.4, 3.5. 106 See sub-s 3.5. 107 For a further discussion about the difference between blockchain and database, see Gareth Peters and Efstathios Panayi, 'Understanding Modern Banking Ledgers Through Blockchain Technologies: Future Of Transaction Processing And Smart Contracts On The Internet Of Money' (SSRN, 2018) <https://papers.ssrn.com/sol3/Papers.cfm?abstract_id=2692487> accessed 5 July 2018. 108 See Bashir (n 99) 21.
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Josh Start, endorsed by the International Swaps and Derivatives Association (ISDA), which considers these
piece of code “as a complement, or substitute, for legal contracts.”109 In practice, this means that a legal
contract can be executed in part or total by a machine. To this purpose, the digital time stamp embedded in
the validation protocol of a transaction could be utilised to indicate that a contract between two parties is
initiated or completed. This feature can improve efficiency in SSSs even though some challenges have yet to
be solved in regard to settlement finality and collateral management.110
1.6 Distributed ledger
A distributed ledger is always a type of shared database across multiple participants (nodes) in which records
are stored one after the other rather than in a block structure. A new record can only be added if a quorum is
reached by participants that validate the new version of the ledger ensuring its integrity. In this way, a
consensus is reached upon the state of the ledger. While this kind of technology is considered less censorship
resistant than a public blockchain, it is significantly faster. The real-time gross settlement system (RTGS)
Ripple is an example.111 Distributed ledgers should not be confused with the terminology used to indicate both
distributed ledgers and blockchain technology: Distributed Ledger Technologies (DLTs).
2 Why is Blockchain attractive to financial markets?
2.1 Introduction
In November 2015, the Bank of International Settlement (BIS) Committee on Payments and Market
Infrastructure (CPMI) said that “Distributed ledgers could in principle be re-engineered and adapted to new or
existing payment systems without necessarily involving the issuance of a digital currency (…).”112 Moreover,
109 Stark identifies a second definition of a smart contract called “smart contract code” intended as a piece of code “governing something important or valuable” on a blockchain. See Josh Stark, 'Making Sense Of Blockchain Smart Contracts' (CoinDesk, 2018) <https://www.coindesk.com/making-sense-smart-contracts/> accessed 5 July 2018; cf ISDA, Smart Contracts and Distributed Ledger – A Legal Perspective (whitepaper, 2017) 4-6 <https://www.isda.org/2017/08/03/smart-contracts-and-distributed-ledger-a-legal-perspective/> accessed 14 August 2018. 110 See sub-s 5.5. 111 See Lee and Deng (n 104). 112 See CPMI, 'Digital Currencies' (BIS 2015) 2 <https://www.bis.org/cpmi/publ/d137.htm> accessed 10 July 2018.
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in 2017, the same committee stated that “[A] DLT arrangement may have possible effects on the overall
financial market architecture.”113 Even one of the most criticised report from the cryptocurrency world of the
BIS, published in June 2018, talks about a promising underlying technology (of cryptocurrencies) in relation to
two aspects: i) the potential combination of “cryptopayments with sophisticated self-executing codes and data
permission systems.”; ii) the adoption of DLTs “by registered exchanges in permissioned protocols that use
sovereign money as backing, simplifying settlement execution.”114 The list goes on. It appears clear that all
reports of the major financial institutions, central banks, and consultancy firms emphasise this new technology
in term of as potentially transformative for FMIs.
This Section analyses the core DLT’s characteristics that could be potentially attractive to financial markets as
described by the reports mentioned above, alongside regulations that may support or contrast these futures.
In some cases, like the one of algorithmic trading, regulations can be seen as an example of how to regulate
specific aspects of this new technology. It has to be noted that not all DLTs have these features, as each of
them depends on the way the system is built. In fact, such characteristics may be questioned or criticised.
However, I firmly believe that with a dedicated platform and the overcome of the challenge of interoperability
among old and new arrangements,115 these attributes can play a significant role within the current legal and
economic framework in financial markets. The five main features consist of:
1. Immutability (Subsection 2.2)
2. Trustlessness (Subsection 2.3)
3. Transparency (Subsection 2.4)
4. Automation (Subsection 2.5)
113 See CPMI, 'Distributed Ledger Technology In Payment, Clearing And Settlement - An Analytical Framework' (BIS 2017) 3.4.2 <https://www.bis.org/cpmi/publ/d157.htm> accessed 11 July 2018. 114Jeremy Allaire, the CEO of Circle (the Goldman Sachs-backed crypto company), told Business Insiders that BIS’ employees “haven't done much research at all clearly. They're looking back at stuff that's year's old, they're not looking at what's actually going on in terms of the real R&D in this space.” The BIS’ report, in Section V, emphasises the problems of the proof of work protocols in terms of scalability and loss of trust while contradictorily mentioning how the industry is responding to these problems in endnote n 27. One of the absurd claims was that the associate communication volumes associated with a large distributed ledger “could bring the internet to halt”. See BIS, 'Annual Economic Report' (2018) 91-110 <https://www.bis.org/publ/arpdf/ar2018e.htm> accessed 9 July 2018; Oscar Williams-Grut, 'Central Bankers Claim Bitcoin Could Break The Internet — The Crypto World Thinks They're Missing The Point' (Business Insider, 2018) <http://uk.businessinsider.com/crypto-responds-to-the-bank-of-international-settlements-bitcoin-report-2018-6?utm_content=buffer67139&utm_medium=social&utm_source=facebook.com&utm_campaign=buffer-ti&r=US&IR=T> accessed 10 July 2018. 115 See sub-ss 5.3, 5.4.
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5. Resilience (Subsection 2.6)
2.2 Immutability
Blockchain’s advocates glorify the immutability of the ledger meaning that once an entry is added into a
validated block, it cannot be unilaterally removed or altered unless a consensus is reached. If on the one hand,
this feature is attractive to participants that may rely on a tamper-proof ledger, on the other, it is not suitable
for an FMI. Hence, in limited circumstances, such as inadvertent errors (fat fingers), fraud, or statutory
reconciliation procedures, the ledger has to be modified to ensure the accuracy, consistency, and
completeness of the database. In addition, a self-executed contract, triggered by those errors, may create or
contribute to a disorderly market in a similar fashion, but in larger scale, as algorithmic trading does as
mentioned by Article 17(1) of markets in financial instruments and amending Directive (MiFID II).116 Hence, by
reference to the Article 17(3) of MiFID II Regulatory Technical Standard (RTS) 6 on the organisational
requirements of investment firms engaged in algorithmic trading, an FMI using a DLT arrangement should also
provide a post-trade reconciliation process that “shall be made in real-time where the aforementioned market
participants provide the information in real-time”.117 This process ensures that internal records are matched
across relevant parties, from the issuer or CSD to all intermediaries. To conclude, blockchain platforms in FMIs
need governance and operational procedures that allow a certain degree of modification of the ledger in the
circumstances mentioned above.118 As explained in Subsection 3.5, the only way to achieve this is through a
restricted blockchain.
116 Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending
Directive 2002/92/EC and Directive 2011/61/EU [2014] OJ L 173/349, art 17 (MiFID II).
117 Commission Delegated Regulation (EU) 2017/589 of 19 July 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards specifying the organisational requirements of investment firms engaged in algorithmic trading [2017] OJ L 87/417, art 17(3), (MiFID II RTS 6). 118 The problem can be solved by adding a new transaction that contains a note that nullifies the wrong transaction by leaving the previous version of the ledger unchanged. The old (wrong) transaction remains on the ledger. However, this may not solve the problem of the right to erasure personal data and can result in a longer ledger that, in turn, results in less scalability. However, more than legal, these are technological problems that, most likely, will be fixed by the blockchain community in the near future.
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2.3 Trustlessness
The decentralised nature of the system is the most attractive feature to financial markets. In theory, it allows
eliminating the need for risk aggregators such as central counterparties (CCPs), central banks, central
securities depositories. Thus, participants in an unrestricted DLT no longer need to trust a central trusted party
since they trust the network that will be responsible for updating the ledger, the code, and maintaining the
truthfulness of the ledger.
Notwithstanding the hype around the potential reduction in costs, the trust is just transferred from well-
grounded financial institutions to the developers, the integrity of the code, and good faith of the majority of
validators. According to Primavera De Filippi, a blockchain researcher at Harvard, Bitcoins technology
“remains subject to the (invisible) politics of a handful of individuals – the programmers who are in charge of
developing the technology and, to a large extent, deciding upon its functionalities.”119 A “technocratic” approach
to governance that goes against Satoshi Bitcoin conception.
Contrarywise, other blockchains projects may involve an on-chain voting system that results in a democratic
governance mechanism with people voting for all changes in the system.120 In this scenario, the trust can rely
on the network as a whole (direct democracy), on representatives (representative democracy), on delegates
(delegative democracy),121 or on proxies (proxy democracy)122. Once again, we need to understand which
governance mechanism satisfies FMIs needs and complies with the current legal framework. In doing so, we
need to understand if financial markets prefer democracy or a technocracy and if the latter should be run by
informal, unknown, and unreliable subjects or by institutional and accountable institutions identified by the
law.123 The answer seems obvious.
119 See Primavera De Filippi and Benjamin Loveluck, 'The Invisible Politics Of Bitcoin: Governance Crisis Of A Decentralised Infrastructure' (2016) 5 Internet Policy Review <https://policyreview.info/articles/analysis/invisible-politics-bitcoin-governance-crisis-decentralised-infrastructure> accessed 13 July 2018. 120 cf Pearson (n 105). 121 In a delegative democracy, also called liquid democracy, “voters can either vote directly or delegate their vote to other voters” which, in turn, “may delegate their own vote to another proxy, and, in doing so, further delegate all the votes entrusted to them.” See Anson Kahng, Simon Mackenzie and Ariel D. Procaccia, 'Liquid Democracy: An Algorithmic Perspective', Thirty-Second AAAI Conference on Artificial Intelligence (AAAI 2018) 1 <https://www.aaai.org/ocs/index.php/AAAI/AAAI18/paper/view/17027> accessed 14 August 2018. 122 In a proxy democracy, voters can either vote directly or delegate their vote to other proxies that cannot further delegate all the votes entrusted to them. 123 See s 3.
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2.4 Transparency
Transparency is one of the most supported blockchain features of traditional public blockchain like Bitcoin or
Ethereum where the ledger is visible to all participants that have an up-to-date version of it. Changes in the
chain can be seen in real time as they are made, and they represent the truth. In financial markets, this would
result in more accurate assets’ prices and reduction of settlement risk.
In the first case, there would be a more effective risk management across system given the higher availability
of information. Moreover, the fact that information could come from one or more trusted interconnected ledgers
thanks to automatic processes enabled by standardised smart contracts should solve the problem of redundant
production.124 There would be no issues of too much or too little information. Hence, a public blockchain would
become the producer of reliable information itself making it available to the public with no restriction in support
of the economic theory that considers information as a public good. 125 In the same fashion, the whole
arrangement would help to reduce costs related to mandatory disclosure regulations,126 mandatory reporting
requirements for post-trade transparency 127 and, traceability for compliance with Anti-Money Laundering
Requirements (AML), Counter-Terrorist Financing Regulations (CTFR) and Know-Your-Customer Rules
(KYC).128
124 Different parties in an FMI may produce information about the same activity with different or similar outcomes resulting in redundant information. At the moment, mandatory market disclosure regulations address this problem. See generally Frank H. Easterbrook and Daniel R. Fischel, 'Mandatory Disclosure And The Protection Of Investors' (1984) 70 Virginia Law Review 669 <https://chicagounbound.uchicago.edu/journal_articles/1177/> accessed 7 August 2018. 125 For further information about this concept, see Richard A Musgrave, The Theory Of Public Finance (McGraw-Hill 1959); Mancur Olson, The Logic Of Collective Action: Public Goods And The Theory Of Groups (Harvard University Press 1975). 126 Directive 2004/109/EC of the European Parliament and of the Council of 15 December 2004 on the harmonisation of transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market and amending Directive 2001/34/EC OJ L 390/38 as amended, (Transparency Directive). 127 MiFID II; Regulation (EU) No 600/2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Regulation (EU) No 648/2012 OJ L 173/84 (MiFIR); Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories OJ L 201/1, art 9 (EMIR); Commission Implementing Regulation (EU) No 1247/2012 of 19 December 2012 laying down implementing technical standards with regard to the format and frequency of trade reports to trade repositories according to Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories OJ L 352/20, art 5 (EMIR RTS 1247/2013). 128 For the impact of DLTs in KYC, AML and CFTR rules, see Advisory Group on Market Infrastructures for Securities and Collateral (AMI-SeCo), 'The Potential Impact Of Dlts On Securities Post-Trading Harmonisation And On The Wider EU Financial Market Integration' (European Central Bank 2017). <https://www.ecb.europa.eu/paym/intro/governance/shared/pdf/201709_dlt_impact_on_harmonisation_and_integration.pdf> accessed 16 July 2018.
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In the second case, the settlement risk would be, in theory, reduced close to zero thanks to real-time
settlement.129 The economic outcome would be more liquidity on the market since there is no more need to
reserve against settlement risk.130 Further, according to the chairman of the United States Commodity Futures
Trading Commission (CFTC), prudential regulators could recognise, in a faster way, anomalies in financial
activities preventing a systemic crisis such as the one of 2008.131
However, the above-described level of transparency granted by a public blockchain does not entirely fit
financial markets for two reasons. First, such transparency may spoil participants’ trading strategies that should
be kept confidential for a healthy and functioning market. Second, financial institutions have privacy obligations
towards their clients’ personal and financial data.132 In conclusion, as stated by the CPMI in its report of 2017,
transparency and traceability “should be weighed against privacy and the need to keep certain information
confidential.”133 This can be achieved only with a permissioned ledger where participants have different layers
of access to information.
2.5 Automation
This concept refers to the ability of a DLT to have attached on the top of it a self-enforcing contract that
executes a part or the totality of a legal contract in automatic.134 The potential of this technology is enormous
in terms of reducing costs in FMIs. For instance, several reports highlighted the possibility to use blockchain
in the clearing and settlement system due to its self-enforcement ability. Besides the execution of legal
contracts, smart contracts can also automate or optimise reporting processes, risk management procedures,
KYC, and AML-CFTR.
129 For challenges related to the real-time settlement, see sub-s 5.5. 130 See Lee and Deng (n 104) sub-s 11.1.2. 131 See J. Christopher Giancarlo, 'Special Address Of CFTC Commissioner J. Christopher Giancarlo Before The Depository Trust & Clearing Corporation 2016 Blockchain Symposium. Regulators And The Blockchain: First, Do No Harm' (Cftc.gov, 2016) <https://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-13> accessed 15 July 2018. 132 For natural persons, financial institutions are subject to Regulation (EU) 2016/679 of the European Parliament and of the Council of 27 April 2016 on the protection of natural persons with regard to the processing of personal data and on the free movement of such data, and repealing Directive 95/46/EC OJ L 119/1 (GDPR). 133 CPMI, 'Distributed Ledger Technology In Payment, Clearing And Settlement' (n 113) sub-s 3.3.5. 134 See sub-s 1.5.
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However, smart contracts do not come without flaws. A bug in the code may lead fraudster or hacker to steal
money.135 Further, smart contracts, triggered by input errors or hacker attacks, may create or contribute to a
disorderly market or, in extreme cases, trigger a systemic event. In using this kind of device, all financial
Institution should always take into consideration the cyber risk as defined in the “Guidance on cyber resilience
for financial market infrastructures” published by the CPMI and IOSCO in 2016.136 According to it, cyber risk
is “The combination of the probability of an event occurring within the realm of an organisation’s information
assets, computer and communication resources and the consequences of that event for an organisation.”137
More specifically, at EU level, according to Article 14 (1) of the “Directive on security of network and information
systems”,138 FMIs (operators of essential services) have to “take appropriate and proportionate technical and
organisational measures to manage the risks posed to the security of network and information systems which
they use in their operations.”139 It has to be noticed that the ability to evaluate this risk in relation to the
codification of smart contracts in order to take appropriate and proportionate measures would be a challenging
aspect for regulators, supervisors, and operators.
Going back to the scope of this analysis, it is important to repeat that one of these measures could involve the
modification of the ledger that has been changed by the erroneous smart contract. This brings up again the
issue of allowing a certain degree of modification of the database.140 In fact, when this cyber risk becomes a
reality, an FMI should be able to recover from the situation in a prompt manner so that, once again, a restricted
network with an efficient and effective governance mechanism may be the best solution. This capability of a
system to recover from or adjust to a change or a disruptive event like a cyber-attack is called resilience.
135 In June 2016, The Decentralised Autonomous Organisation (DAO), an automated venture capital fund built on top of the Ethereum blockchain, was hacked by someone that was able to transfer 60 million of ether (the Ethereum’s currency) to itself. This was possible due to a bug in the software code of smart contracts that run the organisation. In July 2016, the core developers of Ethereum decided to persuade the network to update the software and, by doing so, taking back the hacked ether. This episode demonstrates how core developers in a blockchain possess a centralised power in term of software governance. Eventually, not all miners updated the software. This lead to a hard fork with two blockchains: i) the new Ethereum, and the old one ii) Ethereum Classic with different core developers and miners. See Lee and Deng (n 104) sub-s 11.3.3.3. 136 CMPI and IOSCO, 'Guidance On Cyber Resilience For Financial Market Infrastructures' (BIS-IOSCO 2016) <https://www.bis.org/cpmi/publ/d146.htm> accessed 19 July 2018. 137 ibid Annex A. 138 Directive (EU) 2016/1148 of the European Parliament and of the Council of 6 July 2016 concerning measures for a high common level of security of network and information systems across the Union OJ L 194/1 (NIS Directive). 139 ibid art 14(1); According to ANNEX II (4) of the NIS Directive, a financial market infrastructure is an “operator of essential services” as defined by the point (4) of Article 4. 140 See sub-s 2.2.
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2.6 Resilience
The decentralised structure of the ledger implies that the ledger is stored in an up-to-date and operational copy
on every node in the network. This prevents the possibility of a single point of failure due to a disruptive event
since the database is up and running on every node. Hence, the chance that all node fail simultaneously is
extremely rare. In practical term, there would be no outage of the system fostering the resilience of the whole
financial infrastructure.
This is in harmony with many countries’ regulation of FMIs based on the April 2012 “Principles For Financial
Market Infrastructures” (PFMI) report by the BIS’s Committee on Payment and Settlement Systems (CPSS,
now CPMI) and the Technical Committee of the International Organization of Securities Commissions
(IOSCO).141 According to Annex F (3) “A critical service provider is expected to implement appropriate policies
and procedures, and devote sufficient resources to ensure that its critical services are available, reliable, and
resilient. Its business continuity management and disaster recovery plans should, therefore, support the timely
resumption of its critical services in the event of an outage so that the service provided fulfils the terms of its
agreement with an FMI.”142
At the moment, FMIs replicate their infrastructure in three or four different places, at least one of which is
located in a different region to decrease the likelihood that it is affected in the case of regional disaster.143 The
most distant location can be hundreds of kilometres away from the primary infrastructure so that it will receive
data asynchronously from the primary site. This means that some transactions accounted for in the primary
centre, and in closer synchronised centre, have not been broadcast to the other distant centres by the time
the primary centre stops working.144 DLTs can solve this problem by reducing to zero the maximum amount of
time that can pass before changes to data are saved in other centres (Recovery Point Objective - RPO=0).145
141 CPSS-IOSCO, PFMIs (n 94). 142 This provision can be linked to principle 17 of PFMIs regarding operational risk, and in particular with the key consideration n°7. According to it, an FMI should have a business continuity plan in case of a disruptive event interrupts operations. The FMI’s critical information technology systems should be able to resume operations within two hours following disruptive events, and, in case of extreme circumstances, to complete the settlement by the end of the day of the disruption (Recovery Time Objective – RTO=2h). See sub-s 3.3. 143 See AMI-SeCo (n 128) sub-s 11.2.1. 144 ibid. 145 ibid.
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This is possible because all nodes that have participated to validation of the latest transaction hold an updated
version of the ledger.
Theorizing a restricted blockchain as an arrangement for an FMI, in case of regional disasters, the resilience
feature is maintained if the number of validation nodes necessary to reach the validation quorum resides in a
different region from where the disruptive event occurs. As the AMI-SeCo points out, “a greater network of
validating nodes is more resilient, and consensus algorithm requiring lower quorum ensure availability of the
service against the failure of a higher number of nodes.”146 However, a trade-off is required for two reasons:
“i) a high number of validation nodes increases latency”147 and scalability problems; and ii) a low quorum
increases the risk of organising a cartel of validation nodes that may tamper the ledger with their consensus.148
3 FMIs: restricted or unrestricted DLT?
3.1 Introduction
From the previous analysis, it is clear that the above characteristics have to be balanced with the current needs
of FMIs in terms of operability and regulatory constraints. Today, financial markets rely on a complex
infrastructure shaped by historical and technological innovation and backed by a solid legal framework that
ensures safeness and accountability for both market participants and financial institutions. A complex structure
that seems to work well according to the Bank of International Settlement (BIS) but that can be further improved
by the use of DLT and the implementation of Central Banks Digital Currencies (CBDCs).149 The fundamental
aspect that characterises the whole system is centralisation of the main functions toward central institutions150
to reduce risks and costs of financial transactions and increase reliability, integrity and scalability.
146 ibid. 147 ibid. 148 This is called the 51% attack. In short, whatever 51% of the validation nodes “decides to do is done as the network run through majority rule.” See Lee and Deng (n 104) sub-s 11.3.3.4. 149 See generally Bank of International Settlement, 'Central Bank Digital Currencies' (BIS 2018) <https://www.bis.org/cpmi/publ/d174.htm> accessed 5 April 2018. 150 Central banks, central counterparties (CCP), clearing houses, central securities depositories (CSDs).
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Contrariwise, since 2009, advocates of blockchain technology support a total decentralisation of all those
functions with the aim to dismiss all financial intermediaries starting with the central banks’ monopoly on money
issuance thanks to “a purely peer-to-peer version of electronic cash”.151 Academics have linked this innovation
with F.A. Hayek’s theory of the denationalisation of money 152 and free competition between private
currencies.153 However, on the blockchain community side, it seems that the centralisation of power over
money (monopoly) in the hands of central banks (or governments for Hayek) has returned to be a problem.
This, despite the economic results achieved through the independence of central banks over monetary
policy.154
The purpose of this section is to demystify the possibility of a complete decentralisation of powers in FMIs by
analysing the rationale of FMIs regulation. In doing so, Subsection 3.2 outlines a brief historical introduction of
FMI with a focus on a post-trade market and the importance of central counterparties in reducing counterparty,
operational, settlement, and default risks for market participants.155 Subsection 3.3 analyses the regulatory
framework governing FMIs’ governance arrangements and risk-management with a particular focus on
operational risk. These legal aspects are then related to a potential implementation of unrestricted and
restricted DLTs in FMIs in Subsection 3.4 and 3.5.
3.2 Brief historical evolution of centralisation in FMIs
The financial sector is constantly evolving since the beginning of the civilisation when the first money (clay
tokens) was invented in Mesopotamia.156 Later, the invention of the bill of exchange and the promissory
151 See Satoshi Nakamoto, ‘Bitcoin: A Peer-to-Peer Electronic Cash System’ 1, available at <https://bitcoin.org/bitcoin.pdf> accessed 29 March 2018. 152 See generally Friedrich A. von Hayek, Denationalisation of Money —An Analysis of the Theory and Practice of Concurrent Currencies (3rd edn, IEA 1990). 153 See Policy Department for Economic, Scientific and Quality of Life Policies (IPOL), 'Virtual Currencies In The Eurosystem: Challenges Ahead' (European Parliament 2018) sub-s 2.3.5 <http://www.europarl.europa.eu/committees/en/econ/monetary-dialogue.html> accessed 24 July 2018. 154 Since the end of the 1980s and the beginning of the 1990s, most of the central banks acquired their independence from governments in conducting monetary policy to promote monetary stability. In doing so, they solved one the main problem on which Hayek’s theory is based: the persistent abuse of government over depreciation of currencies to finance themselves. However, the central bank independence raises major economic issues and complex problems in terms of supervision, accountability, democratic legitimacy, and other factors, which exceed the scope of this study. For a comprehensive study of central bank independence, see Rosa Maria Lastra, International Financial And Monetary Law (2nd edn, OUP 2015) paras 2.104-2.194. 155 CCPs also help to reduce market and legal risk. 156 3000 BCE.
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note,157 together with the creation of fiat money158 by the first prototype of the central bank in Amsterdam
during the 17th century159 have paved the way to the modern payments.160
As regarding the root of the modern clearing and settlement systems, the first instance goes back to the
beginning of the 15th century when three municipal banks,161 situated in the Mediterranean trading area, set
up the first interbank clearing system.162 During the restoration of Charles II (1660), London’s goldsmith-
bankers took a step forward in this sector by creating a resilient interbank network based on mutual acceptance
of rival notes and a monitoring system without a formal coordinating institution or a formal regulatory
framework.163
The reasons for the rise of interbank clearing systems were based on the reduction of two types of risk and
their consequent costs: the operational risk and the credit risk involved in any transaction between banks. The
former results mainly in higher probabilities of theft during the transportation of the asset from a bank to
another,164 especially “when the settlement asset was specie or (gold) Bullion”.165 As regarding the credit risk,
this arose from the possibility of counterparty’s default. In such a case, the costs related are inherent to the
loss occurred from the counterparty’s inability to pay its debt. The mutual acceptance systems reduced this
risk and its related costs in two ways. One was through a monitoring practice based on group behaviour.166
The second way was through the prompt redemption of each other’s (banks) claims on behalf of their
customers.167 However, claims of this embryonic system were settled on a bilateral basis every few days. We
157 See generally Sergii Moshenskyi, History Of The Weksel - Bill Of Exchange And Promissory Note (Xlibris 2011). 158 See generally Stephen Quinn and William Roberds, 'How Amsterdam Got Fiat Money' (2014) 66 Journal of Monetary Economics <https://www.sciencedirect.com/science/article/pii/S0304393214000476> accessed 25 July 2018. 159 See generally Stephen Quinn and William Roberds, 'The Big Problem Of Large Bills: The Bank Of Amsterdam And The Origins Of Central Banking' (2005) FRB Atlanta Working Paper No. 16/2005. <https://ssrn.com/abstract=814004> accessed 25 March 2018. 160 Today, payments are made mostly by E-money, cash, and book-money, however, some say that virtual currencies will takeover in the future. Nevertheless, on the institutional side, this possibility is discarded since, at the moment, virtual currencies do not qualify as “money status”. See IPOL (n 153) s 4, para 2. 161 The modern concept of bank dates back to the 14th century when the development of the international trade allows the proliferation of numerous banks in Europe starting from Italy. The Bardi and the Peruzzi families first, and the Medici after dominated the banking market during the 14th and 15th centuries. 162 The three banks were: Taula de Canvi (Barcellona 1401), Banco di San Giorgio (Genoa 1407), and Taula de Canvis i Depòsits (Valencia 1408). See Mark Manning, Erlend Nier and Jochen Schanz, The Economics Of Large-Value Payments And Settlement (Oxford University Press 2009) ch 1.2; At the end of the same century (Venice 1494), Luca Pacioli, an Italian Franciscan friar and mathematician, added another milestone to the financial world with the codification of the double-entry bookkeeping system. See generally Alan Sangster and Giovanna Scataglinibelghitar, 'Luca Pacioli: The Father Of Accounting Education' (2010) 19 Accounting Education 423-438 <https://www.researchgate.net/publication/272304355_Luca_Pacioli_The_Father_of_Accounting> accessed 23 March 2018. 163 Stephen Quinn, 'Goldsmith-Banking: Mutual Acceptance And Interbanker Clearing In Restoration London' (1997) 34 Explorations in Economic History, 411-432 <https://www.sciencedirect.com/science/article/abs/pii/S0014498397906823> accessed 31 March 2018. 164 Operational risk includes human errors, management failure, and inadequate controls. 165 Manning (n 162). 166 See Quinn (n 163) 418; According to Manning, banks were monitoring each other’s ability to over-issue notes, a practice that could have threatened their existence. See Manning (n 162). 167 With this tool, scenarios in which a bank should become insolvent before a claim was redeemed were reduced depending on the time in which that claim was settled: the higher the time, the higher the risk. See Manning (n 162).
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need to wait more than 60 years, in 1841, after the establishment of one of the first bankers’ clearing house in
the world in Lombard Street,168 to see the start of multilateral settlement.169
Moreover, with the interbank market, localised banks started to place their interbank deposit with larger,
centralised banks for several reasons such as safety, reputation, connection with other banks, information
advantages, and easier payment services.170 A natural process that would not require a prior existence of a
central bank.171 However, the need of many states “to employ a bank to carry out certain financial functions
for it [them], such as issuing notes, holding deposits, making payments, and arranging loans at home and
abroad” brought this centralisation process to the next level.172 From this period onwards, central banks
became the main pillar of the settlement process since bankers started to settle in central bank’s notes rather
than specie assets.
Overall, the clearing and settlement infrastructure remained unaltered until the volume of transactions in debt
and equity securities became so large that trading became slow, cumbersome, and expensive. A new strategy
had to be implemented thanks to the electronic innovation: the immobilisation and dematerialisation
systems.173 In 1968, the first CSD the “Central Securities Services” (CCS), now Depository Trust Company
(DTC), was established by the New York Stock Exchange (NYSE)174 “to transfer securities electronically,
eliminating their physical handling for settlement purposes”.175 Starting from that moment, most of paper
certificates and instruments were not physically traded or issued but held (immobilised or dematerialised) in a
centralised electronic ledger of the CSD that will transfer the ownership of securities through the book-entry
accounting system.176 As a result, investors do not hold any certificate, and with multilateral netting, the number
of transactions and risks are further reduced. However, this system added another layer of intermediary risk
to the whole infrastructure, a well-known trade-off for a more efficient and secure market. Finally, with the
168 London 1775. 169 See Manning (n 162). 170 See Charles Albert Eric Goodhart, The Evolution Of Central Banks (MIT Press 1991) 34. 171 ibid. 172 ibid 35. 173 According to UNIDROIT, immobilisation is “The act of durably concentrating the holding of securities certificates with a repository to allow the crediting of an equal amount of securities to securities accounts and the transferability of such securities by the way of book entry.”; Dematerialisation is “The issuance (or re-issuance) of securities which are not represented by a physical certificate. […]”. See UNIDROIT, Legislative guide on Intermediated Securities (2017) xxii, xxiv. 174 See William Spaulding, 'Execution, Clearing, And Settlement' (Thismatter.com, 2018) <https://thismatter.com/money/stocks/settlement-and-clearing.htm> accessed 5 April 2018. 175 'Timeline NYSE' (Web.archive.org, 2018) <https://web.archive.org/web/20100813233211/http://www.nyse.com:80/about/history/timeline_1960_1979_index.html> accessed 5 April 2018. 176 According to CSDR, starting from 2023, all new transferable securities (admitted to trading or traded to trading venue), and starting from 2025 all transferable securities, have to be represented in book-entry form. CSDR art 76 (2).
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availability of low-cost computers at the beginning of the 1980s, internet, and the possibility of processing
information in faster, safer, and more accurate way, e-trading became today’s reality even at consumers’
level.177
What emerges from this analysis is that the history of financial markets has pushed towards a natural process
of centralisation towards reliable financial institutions that have helped to reduce risks and costs of financial
transactions. This happened for payments, clearing and settlement systems. Such reliability has been built
over time, starting with an interbank monitoring system, and finishing up to a substantial, always evolving legal
framework based on international standards, which stands as the foundation of current FMIs.
However, most of blockchain’s advocates say that with the use of DLTs in payment, clearing and settlement
systems, we may assist to a total disruption of the centralised structure, and therefore intermediaries, in favour
of a permissionless decentralised one. The following Subsections debunks this statement by proposing an
alternative solution that complies with the existing PFMI and EU regulation and relies on a permissioned
decentralised network.
3.3 Regulatory framework: PFMI and EU regulation
In the aftermath of the global financial crisis of 2008 (GFC), financial markets learned an important lesson
regarding effective risk management and the importance of strong governance of FMIs together with their
oversight. In 2010, the CPSS and IOSCO began a process to review and update international standard for
FMIs to solve those challenges the GFC has brought to light. The result was a report containing twenty-four
principles (PFMI) categorised into nine broad categories178 “to support the goals of the G20 [group of 20] and
FSB [Financial Stability Board] to strengthen the safety and soundness of the financial markets, including
critical market infrastructures.”179
177 Today’s technology allows high-frequency trading thanks to algorithms that automate trading at high velocity. Other platforms provide financial advice with almost no human intervention thanks to Robo-advisor services based on mathematical rules and algorithms that analyse the market. 178 The nine categories are: (i) general organisation, (ii) credit and liquidity risk management, (iii) settlement, (iv) CSDs and exchange-of-value settlement systems, (v) default management, (vi) general business and operational risk management, (vii) access, (viii) efficiency, and (ix) transparency. 179 CPSS-IOSCO, 'Co-Chairs’ Summary Note For The CPSS-IOSCO Principles For Financial Market Infrastructures' (BIS 2012) 2 <https://www.bis.org/cpmi/publ/d101.htm> accessed 29 July 2018.
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As regarding the risk management, the report intends to address systemic risk, legal risk, operational risk,
credit risk, liquidity risk, custody and investment risk, and general business risk. This Subsection examines
operational risk (principle seventeen) as it is important to understand whether unrestricted blockchains are
suitable for the next revolution of FMIs or not. Also, the PFMI set out general organisation standards that are
minimum requirements for all kinds of risk management. In particular, principle two on the governance structure
of the FMI, and principle three on the framework for the comprehensive management of risks are relevant to
this analysis. Here below the three principles:
“Principle 2: Governance
An FMI should have governance arrangements that are clear and transparent, promote the safety and
efficiency of the FMI, and support the stability of the broader financial system, other relevant public
interest considerations, and the objectives of relevant stakeholders.
Principle 3: Framework for the comprehensive management of risks
An FMI should have a sound risk-management framework for comprehensively managing legal, credit,
liquidity, operational, and other risks.
Principle 17: Operational risk
An FMI should identify the plausible sources of operational risk, both internal and external, and mitigate
their impact through the use of appropriate systems, policies, procedures, and controls. Systems should
be designed to ensure a high degree of security and operational reliability and should have adequate,
scalable capacity. Business continuity management should aim for timely recovery of operations and
fulfilment of the FMI’s obligations, including in the event of a wide-scale or major disruption.”180
Another crucial concept is the one of governance in FMIs. According to the glossary of PFMI, governance is
“[T]he set of relationships between an FMI’s owners, board of directors (or equivalent), management, and
other relevant parties, including participants, authorities, and other stakeholders (such as participants’
customers, other interdependent FMIs, and the broader market)”.181
180 CPSS-IOSCO, PFMIs (n 94). 181 ibid Annex H, 176.
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If we look at the way public blockchains are built today, it is unlikely to think that this technology based on
open-source code run by independent software developers can comply with these three principles and, in turn,
with the European regulation based on them. In this regard, EMIR, MiFID II, and CSDR,182 together with the
related RTS issued by ESMA determine the regulatory framework for the management of operational risk and
governance. These regulations should be used as a model for restricted DLTs infrastructures.
In particular, Article 26(1) and Article 78(1) of EMIR set similar general requirements for a CCP and a TR
respectively. They “shall have robust governance arrangements, which include a clear organisational structure
with well-defined, transparent and consistent lines of responsibility, […], and adequate internal control
mechanisms, including sound administrative and accounting procedure, […].”183
As noted in Subsections 2.2 and 2.5, a blockchain-based infrastructure entails similar features of algorithmic
trading, already regulated by MiFID II, due to the automation of operational processes. To this extent, in a
similar fashion to Article 17(1), DLT systems in an FMI should “have in place effective systems and risk controls
suitable to the business it operates to ensure that its trading systems are resilient and have sufficient capacity,
are subject to appropriate trading thresholds and limits and prevent the sending of erroneous orders or the
systems otherwise functioning in a way that may create or contribute to a disorderly market.” Also, as well as
regulated markets, according to Article 48(1) of MiFID II, DLT systems in a FMI should “have in place effective
systems, procedures and arrangements to ensure its trading systems are resilient, have sufficient capacity to
deal with peak order and message volumes, are able to ensure orderly trading under conditions of severe
market stress, are fully tested to ensure such conditions are met and are subject to effective business continuity
arrangements to ensure continuity of its services if there is any failure of its trading systems.”
Moreover, similarly to Article 3 of MiFID II RTS 7 and Article 1 of MiFID II RTS 6, the overall governance and
decision-making framework of a DLT system in an FMI should ensure “a clear and formalised governance
arrangement” setting out, inter alia, “clear lines of accountability, including procedures to approve the
182 For the implications of the CSDR of FMIs, see s 4. 183 The two articles are the same except for the part in brackets. A CCP shall also have an “[…] effective processes to identify, manage, monitor and report the risks to which it is or might be exposed […]”, EMIR art 26 (1); a TR shall also “[…] prevent any disclosure of confidential information.”, EMIR art 78 (1).
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development, deployment and subsequent updates of [DLT systems] trading systems (algorithms) and to
resolve problems identified when monitoring the [DLT system] trading systems (algorithms).”184
3.4 Why is an unrestricted DLT not suitable for FMIs? A governance issue.
As noted in Section 2, unrestricted blockchains are considered immutable, based on informal democracy or
technocracy governance, totally transparent and highly resilient. However, in an FMI, immutability have to
leave some space to the possibility of a certain degree of modification in certain circumstances. Transparency
has to be mitigated because of privacy and confidentiality issues. Resilience should not impair scalability.
We also saw that, since their origins, FMIs have to deal with operational risks and transaction scalability. To
do so, a historical process led to the centralisation of the system in favour of trusted financial institutions. A
process that has been corroborated by the latest PFMI. It became evident, as stated in principle two, that a
clear and transparent governance arrangement is crucial to the stability of the financial system and “should
promote the safety and efficiency of the FMI.”
The same concepts are restated in EU regulation, as seen in section 3.3, specifying even further the need of
“formalised governance arrangements” with “clear lines of accountability” and “procedures to approve the
development, deployment and subsequent updates of” the software. While software developers may find a
solution to transparency, immutability, and scalability in the future, it is hard to imagine a solution to the informal
governance problem entailed within the nature of a public blockchain that brings additional operational risk to
the whole market infrastructure instead of diminishing it.
To this extent, it is important to mention, and elaborate further, the study of Angela Walsh regarding the open-
source operational risk of public blockchains”.185 According to her, there are three kinds of operational risks in
relation to public blockchains that arise from the same problematics open-source code has when it is initiated
and run by independent software developers: (i) the risk of impeded decision-making about changes in the
184 Trading systems refers to trading venue, Commission Delegated Regulation (EU) 2017/584 of 14 July 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards specifying organisational requirements of trading venues [2017] OJ L 87/350, art 3 (1) (b), (MiFID II RTS 7); trading algorithms refer to investment firms, MiFID II RTS 6 art 1 (a). 185 See Lee and Deng (n 104) sub-s 11.3.
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software code”;186 (ii) the risks of software forks due to both the public availability of the source code and the
lack of legal restriction on copyrights;187 and (iii) the risk of inadequate maintenance and development of the
software due to insufficient and problematic funding.188
As stated in subsection 2.3, with an unrestricted DLT the trust regarding the right functioning of the system is
transferred from well-grounded financial institutions to certain developers. These people may take decisions
about changes in the software code through rough consensus in a technocratic-based system, or by a majority
in a democratic environment. In the latter case, if direct democracy is chosen as decision-making mechanism,
it would be like giving power to the people to decide in matters of national defence or taxation without knowing
anything about international politics or economics. In many countries, this is forbidden by constitutions. On the
other hand, representative, delegative, or proxy democracies’ mechanisms, that may solve the lack of
knowledge issue, still have a slow decision-making process that does not go well with the speed and the
contingency of financial markets. This incompatibility concerning slowness also applies to the mechanisms of
direct democracy.
With a technocratic approach, the decision is made in relation to the dominant view of the group of core
developers (rough consensus) which does not necessarily imply the majority of 51% of the group since it will
be the chair who decides whether the consent has been reached or not.189 In theory, anyone at any time can
develop the software. In practice, most of the time, the developers are concentrated in a few unknown
people.190 At the same time, anyone can step out from the developers’ team with the probability of having an
insufficient number of developers to keep the system up and running 24/7.
This would happen without any legal consequences, either for developers and for the network considered as
a legal entity, given the lack of any “official responsibility for keeping the software operational.”191 The result is
an “unacknowledged centralization of power” with no accountability or supervision on decisions.192 Moreover,
186 ibid sub-s 11.3.1. 187 ibid sub-s 11.3.3. 188 ibid sub-s 11.3.2. 189 The term “rough consensus” was used for the first time by the Internet Engineering Task Force (IETF) in describing its consensus decision-making procedures for working groups (WGs). IETF, 'Working Group Guidelines And Procedures' (1998) sub-s 3.3 <https://tools.ietf.org/html/rfc2418> accessed 5 August 2018. 190 See sub-s 1.2.2. 191 See Lee and Deng (n 104) sub-s 11.3.1.1. 192 ibid.
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since the continuity of the operation of the system is not ensured, financial markets may suffer from paralysis
periods, especially when the system is crucially important. This scenario would occur due to the interruption
of all structures and services built on top of the crashed fundamental system.
As Walsh pointed out, in an FMI, the problem “is not the centralization part, but the unacknowledged part.”
The latter “can lead to the exercise of unaccountable and unchecked power.”193 However, certain public
projects identify a clear, formalised, and transparent governance arrangement that removes the
unacknowledged part in favour of a system that is more compatible with regulations and international standards.
Nevertheless, the nature of an open-source project usually involves an ideological purpose that is related to
the core developers or promoters of the project.194 This purpose influences the decision-making leaving space
for a chance that the decision will not be accepted by the community.
In such a case, the result is a software fork, with a consequent fork of the entire network,195 that leads to one
of the following outcomes: “(a) peaceful co-existence of both old and new software [network]; (b) the old version
of the software die; (c) the new version of the software [network] die; or (d) there is a contentious co-existence
of the old and new software [network].”196 This is possible because the open-source software is available to
everyone and can be modified without legal consequence. On the other hand, the consequences of a fork in
a public blockchain related to an FMI may create serious disruption. Hence, a fork would create fragmentation
in the data structure with two version of the same ledger “undermining the technology’s service as a single,
reliable source of truth.”197
As regarding the funding problem, in general, open-source software developers compile the software code as
an altruistic or reputational activity “outside of their regular paid employment.”198 They do not receive any wage
193 ibid. 194 For instance, Vitalik Buterin is the creator of Ethereum and now leads the Ethereum’s research team shaping the future versions of the Ethereum protocol. A comparison can be made with Linus Torvalds, leader of the Linux open-source project and creator of the Linux Kernel, an open-source operating system kernel. 195 There are two main types of software fork: hard and soft. “A hard fork is a change to a protocol that renders older versions invalid. If older versions continue running, they will end up with a different protocol and with different data than the newer version. This can lead to significant confusion and possible error.” With a soft fork “[…] a protocol is changed in a way that tightens the rules, which implements a cosmetic change or that adds a function that does not affect the structure in any way, then new version blocks will be accepted by old version nodes.” See Noelle Acheson, 'Hard Fork Vs Soft Fork' (CoinDesk, 2018) <https://www.coindesk.com/information/hard-fork-vs-soft-fork/> accessed 8 August 2018. 196 See Lee and Deng (n 104) sub-s 11.3.3. 197 ibid. 198 ibid sub-s 11.3.2.
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for their work meaning that they can abandon the project at any moment increasing the likelihood that bugs
are not fixed, and the system remains out of date. However, Financial institutions may easily support any
project, public or private, if it is convenient for them. Developers may be paid by financial institutions that
benefit from this kind of projects. This would increase the level of developers’ accountability towards the paying
institution.
On the other hand, the lack and of an effective, external, and formal supervision may raise conflict of interest
problems. No one prevents a financing institution from giving directives on software development that favour
it over others. One may argue that the market would fix this issue with participants leaving the unfair
infrastructure in favour of a most reliable one. Take part in this debate exceed the scope of this study. What
can be said here is that, historically, regulations and government have always tried to prevent conflicts of
interest especially after the GFC199 stepping away from the invisible hand concept theorised by Adam Smith.
Given the current legal framework, the root problem is that financial institutions would hardly finance a long-
term public open-source project based on unrestricted DLT for creating new types of FMIs.
My additional claim is that even if the governance arrangement is efficient, transparent, and clear, with paid
developers, the problem of the accountability towards competent authorities remain. At the moment, public
blockchains are not supervised by any financial authority, and they are not considered as components of FMIs.
It would be hard to imagine a single financial supervisor for a network that is decentralised all over the world
and that may be used in different jurisdictions that are not entirely harmonised. Also, public blockchains, given
their open nature, may serve different purposes that exceed those of the financial markets. For instance, health,
supply chain, gaming, energy, and many others at the same time. I ask the reader to think how such a system
can be supervised by a competent financial authority that does not deal with any of the other sectors mentioned
above. This would create competition between financial and non-financial competent authorities on the same
system making enforceability of current laws hard if not impossible. The lack of effective accountability and
enforceability makes regulations useless including the ones against operational risks.
199 EMIR arts 28 (4), 33; MIFID II arts 18 (4), 23, 48 (1) (a); CSDR art 26 (3, 6).
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All of these scenarios do not comply with PFMI and EU regulation analysed in the Subsection 3.3. On the
contrary, they carry on additional layers of operational risks at any level. By looking at the bigger picture, the
potential implications concern not only the backbone of as FMI but also everything that is built on it. For
instance, an investment firm which needs to outsource “important operational functions” to a third party will
find it hard to comply with Article 16 (5) of MiFID II when the third party is a public blockchain. In fact, there are
no “reasonable steps to avoid” the above mentioned “undue additional operational risk” other than relying on
a centralised network or a hypothetical restricted blockchain. This would create redundancy and additional
costs by making the implementation of a public blockchain in an FMI unnecessary.
3.5 Why is a restricted DLT suitable for FMIs?
The only alternative to overcome the outlined problems is a restricted or permissioned blockchain. More
specifically, a restricted tiered arrangement200 would easily comply with all principle and regulations listed in
subsection 3.3.
First, it will be possible to have clear and transparent governance which would be able to guarantee a safe
and efficient FMI in compliance with principle two of PFMI.201 When the code is created and run by a legal
entity,202 whether it is derived by open-source code or not, it is the owner of the software that decides the sort
of the system, its updates, and how much resources should be assigned to the project.
Decisions about software changes will be driven by technical aspects rather than ideological ones so that
decision-making “Committee” would necessarily count on a technocratic, centralised, and transparent body.
This would prevent any fork in the network, and consequently, any fragmentation and redundancy issue.
Therefore, when a hard fork203 is needed due to the complete incompatibility of the new software with the old
one, the only possible outcome is that the old version of the software (and network) will die, leaving the new
version of the ledger the only source of truth, denaturalising the concept of fork itself.
Second, the owner of the software will pay software developers to fix the bugs and update the system so that
the continuity of the services is guaranteed in the long-term. Further, given the transparency of the governance
200 See sub-s 1.4. 201 CPSS-IOSCO, PFMIs (n 1) Principle 2. 202 For instance, CCPs, SSSs, CSDs, or TRs. 203 See n 195.
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arrangement, it will be easy to set up clear lines of accountability and decisional procedures to “approve the
development, deployment and subsequent updates” of DLT systems as required by MiFID II RTS 6 and 7.
Even the problem of the accountability toward competent financial authorities would be solved. Thus, if
distributed systems204 are deployed within a specific territory that shares highly harmonised jurisdictions on
FMIs, there will be no problem in identifying the competent supervisory authorities. In particular, these systems
should be only dedicated to the operation of FMIs. At the EU level, everything would remain unchanged with
the European Banking Authority (EBA), the European Supervisory Authorities (ESAs), the European System
of Central Banks (ESCB), the European Central Bank (ECB), and the European Securities and Markets
Authority (ESMA) carrying out, with a close collaboration, their specific supervisory and oversight tasks for
each FMI.
Third, the whole software governance arrangement together with restricted validation governance allow a
certain degree of modification of the ledger. A crucial aspect for statutory reconciliation procedures or when
inadvertent errors (fat fingers), or frauds may trigger a certain number of smart contracts that may result in a
snowball effect in an almost fully automated market. The validation structure of the nodes should be based on
a permissioned basis to avoid any opposition to the modification of the ledger in the cases mentioned above.
On the other hand, to avoid the problem of tampering with the ledger by 51% of the nodes,205 it is necessary
to identify a number of nodes that is adequate to the scalability of the system and, at the same time, a minimum
quorum that makes tampering impossible. A rotation assignment of the node quality to a number of
predetermined participants bound by a contractual arrangement to the owner of the FMI could help in this
regard. At the same time, the decentralised structure of the ledger theorised in Subsection 1.2.3 would
guarantee the resilience of the system avoiding any point of failure. With this kind of arrangement, the trust
would be shared between the owner of the FMI, the network, and the competent authority for the supervision
of that particular FMI.
Fourth, as regards the access to trading information and transparency, the owner of the network should provide
a tiered permissioned access according to the status of the participant, or supervisor, and always in respect
of non-discriminatory access rules to guarantee a level playing field for participants and consumers. The
204 Meaning that the system is only dedicated to the operation of an FMI. 205 51 % attack, see n 135.
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outcome would be the creation of different layers of access to information for different types of participants
and supervisory authorities. This would allow complete compliance with confidentiality requirements for CCPs,
TRs,206 and CSD,207 and with participation requirements for clearing members in a CCP,208 and for participants
in a CSD.209 Finally, the identification of participants under the supervision of a trusted body (FMIs), that
already have to comply with KYC rules, will simplify AML and CFTR procedures.
4 A case study on Central Securities Depository
4.1 Introduction
As noted in Subsection 3.2, today, the holding of securities usually involves intermediaries. This is always true
in the EU when securities are intended to be sold and traded on capital markets. In particular, securities that
are traded on a trading venue or which “are transferred following a financial collateral arrangement as defined
in point (a) of Article 2(1) of Directive 2002/47/EC”210 have to be “recorded in book-entry form in a CSD on or
before the intended settlement date.”211
This section gives an example of how a restricted DLT can be used by a CSD to carry out its notary function
and reconciliation procedures under CSDR in regard to tradeable securities.212 It is important to remember that
the existing regulatory framework provides essential safeguards for well-functioning securities markets so that
a CSD or an SSS using a DLT that perform regulated services or functions should be mindful of existing
regulations. In particular, RTS on reconciliation procedures issued by ESMA213 offers a sound basis for the
implementation of this technology at the operational level, although slight amendments are required to
guarantee the integrity of the issue and so investor protection.
206 EMIR arts 33 (5), 35 (1) (j), 64 (4). 207 CSDR art 45 (2). 208 EMIR art 37. 209 CSDR art 33. 210 ibid, art 3 (2). 211 ibid. 212 Non-tradable securities are excluded from this analysis since they are usually not subject to regulatory constraints of the CSDR or SFD unless specified otherwise by national law. 213 Commission Delegated Regulation (EU) 2017/392 of 11 November 2016 supplementing Regulation (EU) No 909/2014 of the European Parliament and of the Council with regard to regulatory technical standards on authorisation, supervisory and operational requirements for central securities depositories [2017] OJ L 65/48 (Commission Delegated Regulation (EU) 2017/392).
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4.2 DLTs and CSDs’ notary function and reconciliation procedure
The first step for trading securities on capital markets is their issuance in the primary market. The issuance
process is regulated by the lex societatis (corporate law) applicable to the issuer, or by lex contractus (the law
chosen by the issuer) for certain aspects of debt issuance.214 The EU did not harmonise these laws that remain
of national prerogatives. However, at the operational level, national CSDs, which offer notary, central
maintenance, and settlement services, are all subject to CSDR.215
The first obstacle to the implementation of an unrestricted DLT for issuance services operated by a CSD is
that, under EU regulation, the CSD has a notary function. The initial recording of securities in an issuance
account stored on a public DLT would be carried out by unidentified nodes collectively responsible for
validating the transaction.216 This means that validators may reside in different parts of the word making any
kind of accountability and enforceability difficult if not impossible.
A private DLT run by a CSD could overcome this shortcoming since the validation process is made by trusted,
identified nodes that have been admitted in the network on the base of admission requirements, and respect
of conduct rules and contractual agreements. Validators may be considered as “account operators” under
Article 64(5) of Commission Delegated Regulation (EU) 2017/392. According to this RTS, account operators
are entities that are “contracted by a CSD to record book entries into its securities accounts”, and that must
“provide the CSD with the information that the CSD deems necessary to ensure the integrity of the issue, in
particular to solve any reconciliation problems.”217 Overall, the FMI will oversight this validation process and
detain the central governance to ensure proper handling of operational risk.
On the last point, the duty of a CSD to ensure the integrity of the issue represents the second obstacle.
According to Article 37 of CSDR, a CSD must take appropriate reconciliation measures to verify that the
number of securities debited on the issuance account is equal to the sum of securities recorded on the
securities accounts of investors or participants of the SSS operated by the CSD. Once again, with a public
DLT, this procedure would be carried out by unidentified nodes so that no legal entity would bear responsibility
214 See AMI-SeCo (n 128) sub-s 3.1.1. 215 The core services of CSDs are: “1. Initial recording of securities in a book-entry system (‘notary service’); 2. Providing and maintaining securities accounts at the top tier level (‘central maintenance service’); 3. Operating a securities settlement system (‘settlement service’).” CSDR Annex, s A. 216 See AMI-SeCo (n 128) sub-s 3.2. 217 Commission Delegated Regulation (EU) 2017/392.
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for it. Moreover, a public arrangement presents all drawbacks examined in section 3.4 regarding the
immutability of the ledger so that “the private key to modify the number of assets in circulation in the DLT
network would need to remain under the control of the operator [issuer CSD].”218
It should be noted that immutability (or truthfulness) of the data is one of the main benefits of DLT and that
some DLTs use single-entry bookkeeping with cryptographic linkages instead of double-entry bookkeeping. In
this case, notary checks on the correspondence between the number of securities in the issuance and
securities accounts (reconciliation) are guaranteed by proper cryptographic algorithms that link those accounts
without letting “anything to get in or out of the network after its content has been determined by the operator.”219
In order for a DLT to be implemented in a CSD system, ESMA should update its current RTS regarding
reconciliation measures.220 In particular, the third subparagraph of Article 59(1) should include the possibility
to use single-entry accounting based on cryptographic algorithms, besides the double-entry system.
Moreover, a fifth paragraph should be inserted to guarantee the truthfulness of the ledger in case the
reconciliation procedures specified in Articles 59, 60, 61, 62, and 63 are carried out with a single-entry
accounting system. This amendment should provide that every change made by a CSD and occurred in the
ledger following the reconciliation procedures shall be traceable. Such traceability should be implemented at
the software level, and the part of the code should be disclosed to the competent authority. In this way, a smart
contract can automatically create a report of any correction that can be automatically sent to “participants,
competent authority, relevant authorities and the other entities involved in the reconciliation process that are
referred to in Articles 61, 62 and 63” as provided by Article 65 of the same RTS. Also, such an arrangement
would add additional layers of security, transparency, and trust over the ledger fostering investor protection.
5 Challenges
218 See AMI-SeCo (n 128) sub-s 3.3. 219 ibid sub-s 3.3.2. 220 Commission Delegated Regulation (EU) 2017/392.
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5.1 Introduction
Regardless of the type of DLT, the implementation of such a technology in an FMI gives rise to certain
challenges both at the regulatory level and operational level. This section examines five of them being aware
that they are not the only ones. The aim is to demonstrate that despite the congruence of restricted DLTs with
many aspects of FMIs, their possible large-scale implementation in the medium-term is impossible without
progress in both regulatory harmonisation and technical solution.
Subsection 5.2 deals with the need for harmonisation of the securities issuance process at national level.
Subsection 5.3 faces the problem of lack of interoperability between SSS and payment systems in DvP
procedures. Subsection 5.4 analyses the same problem of interoperability from an external perspective
between FMIs’ DLTs and other external participants’ systems. Subsection 5.5 considers the incompatibility of
DLTs with SFD and CSDR in relation to the opening of insolvency proceedings against participants. Finally,
Subsection 5.6 points out the problem of the nature of the asset registered on a DLT in relation to collateral
management.
5.2 Harmonisation of the issuance process
As noted in subsection 3.2, the issuance process is regulated by national corporate law that is not harmonised
at the EU level. It is for the applicable national law to determine whether securities can be issued by using a
DLT network. For instance, in Germany, the establishment of securities requires the creation of a physical
certificate preventing the full digitalisation of securities with DLTs. 221 Harmonisation over the securities
issuance to foster full digitalisation would help the deployment of DTLs in FMIs.
5.3 SSS and payment systems interoperability in DvP
Even if a restricted DLT is implemented for the issuance of securities and SSS, Article 39(7) of the CSDR
requires that “all securities transactions against cash between direct participants in a securities settlement
221 See ESMA (n 94) 105.
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system operated by a CSD and settled in that securities settlement system shall be settled on a DvP222 basis”.
Under current regulations,223 the cash leg of the securities settlement shall be settled in central bank money
(CeBM) where practical and available to avoid credit and liquidity risks, or in commercial bank money (CoBM)
if CeBM is not used. This creates a challenge regarding the interoperability of SIPS and DLT systems deployed
for securities settlement. Whether cash is directly represented in the ledger, or in a separate DLT through a
potential central bank virtual currency, or whether the DLT interacts with non-DLT system exceed the scope
of this study.224 However, interoperability and harmonisation between different technologies or different DLT
systems is conditional to the delivery and yet to be implemented.
5.4 FMIs and external systems interoperability
Interoperability is also crucial for different aspects of the whole FMI. For instance, in the post-TARGET2-
Securities environment, issuer or issuer’s agents can have a distribution account in one CSD that is different
from the issued CSD so that they can pool their distribution activities with one CSD while issuing securities in
different markets.225 Further, according to national law, an issuance process or reconciliation process may
involve other actors such as custodians, registrars, national numbering agencies, and others. New DLT system
should be arranged by taking into consideration both harmonisation and interoperability with all relevant
systems.
5.5 Settlement finality in insolvency proceedings
Articles 3(1)(2), and 6(1) of SFD set up the regulatory framework regarding the challenge of settlement finality
in insolvency proceedings with a DLT. However, to better understand the issue CSDR and ESMA guidelines
on this matter offer a clearer example. CSDR requires CSDs to “have effective and clearly defined rules and
222 “DvP is settlement mechanism that links a securities transfer and a funds transfer in such a way as to ensure that delivery occurs if and only if the corresponding funds transfer occurs.” See CPSS-IOSCO, PFMIs (n 94) 152. 223 See CPSS-IOSCO, PFMIs (n 94) Principle 9; CSDR Art 40(1), Recital 44; Regulation of the European Central Bank (EU) No 795/2014 of 3 July 2014 on oversight requirements for systemically important payment systems (ECB/2014/28) [2014] OJ L 217/16. 224 On this matter, see AMI-SeCo (n 128) sub-s 4.2; IPOL (n 153) s 3. 225 See ECB – Eurosystem, 'Topic 6: Issuance Practice – Draft' (2012) ch 2.1.2, para 6-11 <https://www.ecb.europa.eu/paym/t2s/progress/pdf/subadapt/minicon1/2012-06-27_Solution_Outline_Issuance_practices.pdf?532ac522c0c40ae1af41614a5c687631> accessed 13 August 2018.
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procedures to manage the default of one or more of its participants.”226 According to ESMA guidelines, a CSD
shall have the ability to suspend or terminate its participants’ access to its SSS when participants are defaulting,
and the default has been identified.227 A real-time or near-real-time settlement in a DLT solution would give no
time to the CSD to suspend access to defaulting participants right after the opening of the insolvency
proceedings against them. This result in the possibility for defaulting participants to enter a significant amount
of transfer order instructions into the system, with the consequent settlement, before the operator is able to
suspend the access. Such a scenario would pose a threat to the compliance with settlement finality rules and
so increase systemic risk.228
5.6 Nature of the asset in DLTs and collateral management
Even though restricted DLT may offer potential advantages for collateral management in FMIs,229 in terms of
nature of the assets recorded on the ledger, there is no “certainty on whether a position in the ledger constitutes
full title or another form of entitlement. In addition, these positions in the DLT network would need to be
recognised as collateral under the applicable law.”230 Once again, national law is not harmonised on this matter.
Therefore, a harmonised regulation is required at EU level.
Conclusions
This paper examined the implementation of restricted DLTs in EU FMIs instead of unrestricted ones. Although
advocates of public or unrestricted DLTs promote the implementation of such arrangements for FMIs due to
their main characteristics, a trade-off that loosens them is necessary for the arrangement to comply with current
regulatory framework. This trade-off can be easily met with a restricted DLT.
226 CSDR art 41 (1). 227 See ESMA, 'Guidelines On Participant Default Rules And Procedures Under Regulation (EU) No 909/2014' (2017) ch 3, para 31 <https://www.esma.europa.eu/regulation/post-trading/settlement> accessed 13 August 2018. 228 See AMI-SeCo (n 128) sub-ss 5.2.2, 5.2.3. 229 ibid sub-ss 8.2.1, 8.2.2, 8.2.3. 230 ibid sub-s 8.2.3.
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In particular, immutability should compete with governance and operational procedures that allow a certain
degree of modification of the ledger to correct inadvertent errors, restore the situation after frauds, or to carry
out statutory reconciliation procedures. This is only possible with a restricted DLT.
Trusting only the network is not sufficient to guarantee investor protection and prevention of systemic risks. In
fact, it is hard for a financial supervisory authority to supervise a public network. Trust should be shared
between the owner of the FMI, the network, and the competent authority for the supervision of that particular
FMI. This is only possible with a restricted DLT.
The transparency provided by unrestricted DLTs is important to achieve more accurate assets’ prices,
reduction of settlement risk and help to reduce costs related to mandatory disclosure regulations, mandatory
reporting requirements for post-trade transparency and, traceability for compliance with KYC, AML and CFTR.
However, transparency and traceability should compete against privacy and the need to keep certain
information confidential. This can be achieved only with a restricted DLT where participants have different
layers of access to information.
Smart contracts can drastically reduce costs of clearing and settlement procedures and reporting processes.
However, due to their capacity to automate processes and cyber risks attached to them, they may trigger
systemic event in a similar fashion of algorithmic trading. For this reason, regulators should take into
consideration MiFID II and MiFID II RTSs on algorithmic trading in regulating DLTs. The same conclusion on
immutability regarding governance also applies to automation.
Resilience is crucial for FMIs, and DLTs may contribute to render the whole financial market more resilient.
However, the arrangement should be set up in such a way as not to decrease the scalability and, at the same
time, to keep the database safe and tamper-proof. Only a restricted DLT can meet such requirements.
The historical evolution of the centralisation of FMIs is important to understand the reasons why today’s
regulations require FMIs to have formal governance arrangement to manage risks. Unrestricted DLTs struggle
to meet any requirement on this matter. This happens regardless of the implementation of democratic or
technocratic governance models. On the other hand, a restricted DLT with a technocratic governance
arrangement subject to supervisory financial authority would have no problem to manage risks.
Restricted DLTs can easily meet the almost all the requirements for a CSD to carry out its notary function and
reconciliation procedures as required by CSDR. However, slight amendments are required to guarantee the
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integrity of the issue and so investor protection. In particular, RTS regarding reconciliation measures should
include the possibility of a CSD to use single-entry accounting based on cryptographic algorithms, besides the
double-entry system. Moreover, the truthfulness of the ledger should be guaranteed by adding a provision that
ensures traceability and reporting requirements of any correction made by the CSD on the database.
The need of harmonisation of the securities issuance process at national level, the lack of interoperability
between SSS and payment systems in DvP procedures, the lack of interoperability between FMIs’ DLTs and
other external participants’ systems, the incompatibility of DLTs with SFD and CSDR in relation to the opening
of insolvency proceedings against participants, and the problem of the nature of the asset registered on a DLT
in relation to collateral management represent, inter alia, some of the challenges that have to be solved in
order to allow restricted DLT to be deployed on a large scale.
List of abbreviations
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AMI-SeCo
AML
BIS
CCP
CCS
CFTC
CFTR
CPMI
CPSS
CSD
CSDR
DAO
DLT
DTC
DvP
EMIR
ESMA
EU
FMI
FSB
G20
GDPR
GFC
IETF
IOSCO
IPOL
KYC
MiFID II
MiFIR
NIS
NYSE
PFMI
RTGS
RTS
SFD
SIPS
SSS
TR
Advisory Group on Market Infrastructures for Securities and Collateral
anti-money laundering
Bank of International Settlement
Central Counterparties
Central Securities Services
Commodity Futures Trading Commission
Counter-Terrorist Financing Regulations
Committee on Payments and Market Infrastructure
Committee on Payment and Settlement Systems
Central Securities Depository
Central Securities Depository Regulation
Decentralised Autonomous Organisation
Distributed Ledger Technology
Depository Trust Company
Delivery versus Payment
European Market Infrastructure Regulation
European Securities and Markets Authority
European Union
Financial Market Infrastructure
Financial Stability Board
Group of 20
General Data Protection Regulation
Global Financial Crisis
Internet Engineering Task Force
International Organization of Securities Commissions
Policy Department for Economic, Scientific and Quality of Life
Know Your Customer
Markets in Financial Instruments Directive II
Markets in Financial Instruments Regulation
Network and Information Security directive
New York Stock Exchange
Principles of Financial Market Infrastructure
Real Time Gross Settlement
Regulatory Technical Standard
Settlement Finality Directive
Systemically Important Payment Systems
Securities Settlement Systems
Trade Repositories
95 of 134
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Distributed Ledger Technology and Asset
Securitisation: an analysis of the benefits and the regulatory challenge to this framework
Victor Da Silveira Vieira
ABSTRACT
Within the current framework of financial technologies, the rise of distributed ledgers appears as a promising
component to the improvement of this innovative field. Despite being commonly related to virtual currencies,
the global financial markets are currently directing their attention to distributed ledger technology (‘DLT’) and
realising that its application to financial services may provide significant benefits to investors and potentially
reshape the way financial markets are known. In this context, the asset securitisation industry is being
considered as one of the fields that could mostly benefit from distributed ledgers. This is because DLT is
deemed to have the capacity to address the problems highlighted by the Global Financial Crisis of 2008 which
have tarnished the securitisation industry. However, the paper considers that regulatory uncertainty remains
as a challenging obstacle to this new framework. As at the present day no legal framework covers the use of
DLT in financial activities, there is no certainty whether regulators will allow the application of this technology
to securitisation or, especially, how would be the approach taken by them to deal with this innovation. Thus,
the aim of this paper is to clarify if there are consistent legal grounds for regulators to embrace DLT and
securitisation and, mainly, to suggest the most adequate regulatory strategy that regulators should take to
consider this framework. To this purpose, the paper provides an explanation of the main concepts of DLT and
demonstrates how securitisation could benefit from this technology. In this way, the paper critically evaluates
the possible approaches that could be taken by regulators to deal with the application of DLT to financial
activities as securitisation and proposes that there are consistent legal grounds to support the use of DLT in
securitisation, considering the higher degree of transparency that it could provide for the benefit of investors
protection. The research brings proposals of the most suitable approach that should be taken by regulators to
cope with this innovation.
Keywords: asset securitisation – distributed ledger technology – Global Financial Crisis – regulation –
innovation – transparency – securities laws
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TABLE OF CONTENTS
INTRODUCTION
1. DISTRIBUTED LEDGER TECHNOLOGY AND ITS
IMPACT TO THE GLOBAL FINANCIAL MARKETS
1.1. Blockchain: A New Trend in the Market
1.2 The Rise of a New Financial Infrastructure
2. DLT AND THE CASE FOR ASSET SECURITISATION
2.1 Securitisation as a ‘Causa Proxima’ of the Crisis
2.2 Securitisation and DLT: A New Hope for the Industry?
3. REGULATORS AND THEIR APPROACHES TO
FINANCIAL INNOVATION
3.1 Regulatory Uncertainty: A Challenge to be Addressed
3.2 Regulation and DLT: Possible Approaches by
Regulators
3.2.1 Wait and See Approach
3.2.2 Issuance of New Regulation
4. DLT AND SECURITISATION: ACHIEVING THE AIM OF
SECURITIES LAWS AND A REGULATORY MODEL TO BE
FOLLOWED
4.1 Why regulators should embrace DLT and
Securitisation?
4.2 Regulatory Sandboxes: A Do no Harm Proposal for DLT
and Securitisation
CONCLUSIONS
BIBLIOGRAPHY
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Introduction
During the recent decades, technology could be considered as one of the main drivers for humans`
development. Society has been witnessing a constant growth of new technological improvements which are
affecting the way citizens interact with each other.231 Following this trend, importance is currently being posed
to the impact of technologies on financial services, giving rise to a new field of interest known as ‘Fintech’.232
In a report conducted by the UK Treasury, Fintech was defined as ‘high-growth organisations combining
innovative business models and technology to enable, enhance and disrupt financial services’.233 In this
context, at the present moment, the eyes of financial markets participants are mostly turned into distributed
ledger technology (‘DLT’), an innovative system famously known for underpinning the virtual currency
Bitcoin234 and deemed to have the potential to dramatically revolutionise the way capital markets function.235
As one of the most relevant components of the Fintech revolution, DLT is considered to be a shared
platform where information could be stored through cryptography and accessed by all their members, creating
an environment based on transparency and safety. 236 Thus, there are many institutions and market
participants that are directing their efforts to the possible implementation of DLT to financial services,
supporting that this technology could, in fact, redesign the future of the financial infrastructure.237 In this way,
it is widely discussed that one of the promising areas which could benefit from DLT is asset securitisation.238
The issuance of asset-backed securities (‘ABS’) is considered to be one of the factors that contributed to the
collapse of the global markets during the global financial crisis of 2008 (‘Crisis’).239 Indeed, the facts occurred
during the Crisis brought into light weaknesses identified in the process of structuring ABS which are mostly
related to the lack of proper information that was given to investors and the overreliance on credit rating
agencies` assessments.240 Considering this problematic framework, there are commentators who propose
that DLT could efficiently address these problems.241 This is because, by implementing DLT through all the
231 See Steve Woolgar, Virtual Society? Technology, Cyberbole, Reality (2th edn, Oxford University Press, 2002) 1-2. 232 See George A Walker, ‘Financial Technology Law: A New Beginning and a New Future’ (2017) Volume 34, Number 3 GPSolo Magazine 76. 233 See UK Treasury, ‘UK FinTech – On the cutting edge. An evaluation of the international FinTech sector’ (2015) 21 <https://www.ey.com/Publication/vwLUAssets/EY-UK-FinTech-On-the-cutting-edge/%24FILE/EY-UK-FinTech-On-the-cutting-edge.pdf> accessed 29 March 2018. 234 For the definition of virtual currencies, see the one proposed by the Financial Action Task Force, which defines virtual currency as ‘a digital representation of value that can be digitally traded and functions as: (1) a medium of exchange; and/or (2) a unit of account; and/or (3) a store of value, but does not have legal tender status (i.e. when tendered to a creditor, is a valid and legal offer of payment) in any jurisdiction.’ In this way, see FATF, ‘FATF Report Virtual Currencies Key Definitions and Potential AML/CFT Risks’ (2014) available at <http://www.fatf-gafi.org/media/fatf/documents/reports/Virtual-currency-key-definitions-and-potential-aml-cft-risks.pdf> accessed 15 July 2018. 235 See generally World Economic Forum, ‘The future of financial infrastructure: An ambitious look at how blockchain can reshape financial services’ (2016), <http://www3.weforum.org/docs/WEF_The_future_of_financial_infrastructure.pdf> accessed 29 March 2018. 236 See UK Government Office for Science, ‘Distributed Ledger Technology: beyond block chain’ (2016) 5-8, <https://www.gov.uk/government/news/distributed-ledger-technology-beyond-block-chain> accessed 29 March 2018. 237 See generally WEF (n 5). 238 See generally Lewis Rinaudo Cohen, Lee Samuelson and Hali Katz, ‘How Securitization can benefit from Blockchain Technology’ (2017) Volume 23 The Journal of Structured Finance. 239 ibid; see also American Securities Exchange Commission, ‘Asset-Backed Securities Disclosure and Registration’ (2014) 12, <https://www.sec.gov/rules/final/2014/33-9638.pdf> accessed 29 March 2018. 240 ibid 10. 241 See generally Cohen, Samuelson and Katz (n 8); and Deloitte & Touche LLP, Structured Finance Industry Group and the Chamber of Digital Commerce, ‘Applying blockchain in securitization: opportunities for reinvention’ (2017) available at <https://www2.deloitte.com/us/en/pages/regulatory/articles/applying-blockchain-in-securitization.html> accessed 29 March 2018.
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stages of a securitisation transaction, this technology might provide a higher degree of transparency to this
market and, consequently, bring confidence back to ABS` investors.242
Despite the benefits that DLT may offer to asset securitisation, legal issues appear as
challenging obstacles to this new framework. It can be observed that one legal consideration is related to the
approach that regulators may take with respect to the use of DLT in securitisation. That is to say, as there is
still no consistent legal framework that covers DLT, questions remain whether regulators will allow the use of
this technology in financial activities, such as securitisation, or which approach will be taken by them to deal
with this innovation.243 Following this uncertain scenario, the aim of this paper is to consider the potential
application of DLT to securitisation and if there are legal grounds for regulators to embrace the use of this
technology and, mainly, to evaluate which should be considered the most suitable approach to be taken by
them to deal with this innovation. To this purpose, firstly, Section 1 briefly explains the key components of DLT
and its potential impact on the global financial markets. Thereafter, Section 2 provides an explanation of the
problems linked to securitisation highlighted by the Crisis and demonstrates the benefits that DLT could provide
to these transactions. Furthermore, in Section 3, this paper clarifies that regulatory uncertainty may hinder the
referred implementation and critically analyses the possible approaches that could be taken by regulators to
deal with this innovation. In Section 4, this paper considers the legal reasons that might support the application
of DLT to securitisation and, finally, seeks to suggest an adequate regulatory model for regulators to follow in
order to embrace this proposed framework and address the current regulatory challenge.
242 ibid. 243 See Harold Primm, ‘Regulating the Blockchain Revolution: A Financial Industry Transformation’ (2016) Volume 36 Review of Banking & Financial Law 84-85; and Deloitte, SFIG and CDC (n 11) 21.
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Section 1 – Distributed Ledger Technology and its Impact to the
Global Financial Markets
1.1. Blockchain: A New Trend in the Market
Considering the disruptive framework brought by Fintech, DLT has been broadly claimed as one of
the most promising technologies of this field and, therefore, defining its key concepts seems to be pertinent
for the purpose of this paper. In this regard, it appears vital to consider the DLT`s definition given by the UK
Treasury which has defined this technology as ‘an asset database that can be shared across a network of
multiple site, geographies or institutions’.244 Thus, what could be understood by this definition is that DLT
provides digital ledgers where assets, transactions or information can be stored in a historical order and be
widely available to their members (commonly known as nodes).245 In this way, it seems that the real disruptive
feature of this technology relies on its distributed essence.246 To clarify this, different from a centralised
structure, the information kept on a distributed ledger (including past records) is available to each of its
members who can directly access it at their own discretion, mitigating the need for a central entity to control
information.247 Therefore, this outlines that there is a clear degree of disintermediation within the objectives
of distributed ledgers, a feature that could challenge the common centralised system as the one applied by
banks for example.
Explained the distributed characteristic of DLT, the provision of a complete picture of this technology
must also cover a famous term belonged to this framework: the blockchain. In simple words, blockchain is one
of the different kinds of DLT and, probably, have its popularity linked to the heated world of virtual currencies,
since it is the system that underpins Bitcoin.248 On this path, what differs blockchain from other types of
distributed ledgers is the fact that it is a ‘database that takes a number of records and puts them in a block’.249
Put it simply, each transaction included in a blockchain is collected into a block and linked to the next block
through cryptography, hence, the information bundled in this system remains securely protected by computer
code encryption.250 Furthermore, it is worth mentioning that the immutability of the information stored on a
blockchain is also a crucial advantage of this technology. This is because, by connecting the blocks with
cryptography, it might be impossible to change information of one block without revalidating the data of the
previous blocks which seems to result in the creation of an immutable environment.251 Lastly, there is also
244 See UK Government (n 6) 5. 245 See Dion Blummont, ‘Blocking the Future? The Regulation of Distributed Ledgers’ (2017) Victoria University of Wellington Legal Research Paper, Student/Alumni Paper No 37/2017 2-3 available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3016210> accessed 29 March 2018. 246 See European Securities and Markets Authority, ‘The Distributed Ledger Technology Applied to Securities Markets’ (2017) 4 available at <https://www.esma.europa.eu/system/files_force/library/dlt_report_-_esma50-1121423017-285.pdf> accessed 29 March 2018. 247 See International Swap & Derivatives Association and Linklaters, ‘Whitepaper Smart Contracts and Distributed Ledger – A Legal Perspective’ (2017) 7 available at <https://www.isda.org/a/6EKDE/smart-contracts-and-distributed-ledger-a-legal-perspective.pdf> accessed 29 March 2018. 248 ibid 7; see UK Government (n 6) 5. 249 See UK Government (n 6) 17. 250 ibid; see Michèle Finck, ‘Blockchain Regulation’ (2017) Max Planck Institute for Innovation & Competition Research Paper No 17-13 4 available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3014641> accessed 29 March 2018. 251 See Deloitte, SFIG and CDC (n 11) 3.
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noteworthy importance to classify distributed ledgers into two different categories. The first one is represented
by the ‘permissionless’ or public ledgers, a type of DLT that does not impose any restrictions to their
participants (i.e. everyone may freely enter the system and access information), since no central intermediary
manages the network.252 The Bitcoin’s blockchain is deemed to be the most famous public DLT, providing a
peer-to-peer network based on full disintermediation.253 On the other side, in ‘permissioned’ or private
distributed ledgers, there are one or more agents who act as administrators of the ledger, holding powers to
discretionary restrict the entry of new members and to maintain privacy to some information when
necessary.254 Despite having a degree of centralisation, a private blockchain may avoid the entry of dishonest
parties, therefore, it is being currently used by some of the major financial institutions as Goldman Sachs and
Barclays.255 Thus, this explanation of the key aspects related to DLT leads this paper to provide a brief
description of the smart contracts` framework, since these tools are normally considered together with DLT.256
Since its initial proposal, there is no unquestioned definition of a smart contract.257 However, this paper
adopts the concept proposed by Alexander Savelyev who defines smart contract as a: ‘a piece of software
code, implemented on Blockchain platform, which ensures self-enforcing and autonomous nature of its terms
triggered by conditions defined in advance and applied to Blockchain- titled assets.’258 From this concept, it
could be understood that a smart contract seems to be a computer tool that formalises contractual terms
agreed between parties into a digital coded form.259 Therefore, parties may have a platform where agreed
provisions could be implemented into software codes which might, as a consequence, bring certainty to
contract law. 260 Furthermore, as a smart contract is designed through computer codes, its execution is
completely automated, hence, the obligations are exclusively performed through the running of the codes,
independently from any human intervention.261 This automation of smart contracts outlines its importance to
DLT, since distributed ledgers might provide an appropriate environment to this self-execution.262 In this
context, institutions are recognising the benefits that smart contracts could bring to financial activities. For
instance, the International Swap & Derivatives Association (‘ISDA’) is currently considering the use of smart
contracts in derivatives transactions by integrating them into the ISDA documentation framework.263 Thus, vital
importance is being posed to the potential application of smart contracts and DLT to financial activities as will
be further addressed by this paper.
252 See ISDA and Linklaters (n 17) 8. 253 See Satoshi Nakamoto, ‘Bitcoin: A Peer-to-Peer Electronic Cash System’, available at <https://bitcoin.org/bitcoin.pdf> accessed 29 March 2018. Bitcoin is a virtual currency designed by an unknown person or group of persons called Satoshi Nakamoto. 254 See Deloitte, SFIG and CDC (n 11) 5 255 See Jean Bacon, Johan David Michels, Christopher Millard and Jatinder Singh, ‘Blockchain Demystified’ (2017) Queen Mary School of Law Legal Studies Paper No 268/2017 19; and Kadhim Shubber, ‘Blockchain initiative pulls in another 13 banks’ (Financial Times, September 2015), available at <https://www.ft.com/content/72ffd222-66be-11e5-97d0-1456a776a4f5> accessed 29 March 2018. 256 See ISDA and Linklaters (n 17) 8. 257 See Alexander Savelyev, ‘Contract Law 2.0: «Smart» Contracts as the Beginning of the End of Classic Contract Law’ (2016) Basic Research Program Working Papers Series Law at the National Research University Higher School of Economics (HSE) 7 available at <https://wp.hse.ru/data/2016/12/14/1111743800/71LAW2016.pdf> accessed 29 March 2018. 258 ibid 15. 259 See Savelyev (n 27) 12. 260 ibid; see Max Raskin, ‘The Law and Legality of Smart Contracts’ (2017) Georgetown Law Technology Review 305 309. 261 ibid; Savelyev (n 27) 15. 262 ibid 314; see ISDA and Linklaters (n 17) 8. 263 See generally ISDA and Linklaters (n 17).
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1.2. The Rise of a New Financial Infrastructure
Technology is changing the way that businesses are undertaken, Airbnb in the housing sector
and Uber in cars are just a few examples of innovative companies disrupting their respective markets.264
Following this trend, financial markets actors and international organisations are conceiving the potential
application of DLT to financial services, a tendency that promises to redesign the structure of the current
markets.265 It is widely claimed that DLT`s platforms could have the potential to disrupt the foundations of the
global capital markets, mainly because of the new framework based on disintermediation.266 Therefore, apart
from the virtual currencies, it has been argued that DLT could broaden their application to other assets traded
on financial markets.267 For example, this technology may promote a place where securities could be settled
and cleared on a DLT platform268 between parties without the need for a third intermediary.269 In the same
trend, the Foreign Exchange Market (‘FX Market’) is also a promising case for the use of DLT, since it seems
that this technology may provide a higher degree of transparency to this market through the storage of foreign
currency prices on a common decentralised ledger as blockchain.270 Following this tendency, it is argued that
securitisation is one the fields that could significantly benefit from DLT, since this technology appears to have
the capacity to address many of the problems highlighted by the Crisis which have tarnished the securitisation
industry. Thus, this proposed issue will be further discussed by this paper.
264 See Goldman Sachs, ‘Profiles in Innovation Blockchain Putting Theory into Practice’ (2016) 13 available at <https://msenterprise.global.ssl.fastly.net/wordpress/2017/07/Goldman-Sachs-Blockchain-putting-theory-to-practice.pdf> accessed 29 March 2018. 265 See generally WEF (n 6). 266 ibid. 267 See Philipp Paech, ‘The Governance of Blockchain Financial Networks’ (2017) Modern Law Review LSE Legal Studies Working Paper No 16/2017 3 available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2875487> accessed 29 March 2018. 268 ibid 3-4. 269 ibid 8; see also Blummont (n 15) 11. 270 See Jason Leinwand, ‘How blockchain technology could change FX’ (Banking Exchange, 2017), available at <http://www.bankingexchange.com/news-feed/item/7211-how-blockchain-technology-could-change-fx> accessed 18 June 2018.
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Section 2 – DLT and the Case for Asset Securitisation
2.1. Securitisation as a ‘Causa Proxima’271 of the Crisis
The events following the Crisis have demonstrated significant flaws in the securitisation process
which seem to have contributed to the collapse of the global markets. However, before explaining the role
played by securitisation to the Crisis, it appears relevant to mention the main features of this kind of financial
transaction. To precisely explain, an asset securitisation transaction can be defined as the ‘issuance of bonds
backed by a pool of receivables or other assets (hence ‘asset-backed securities’ or ‘ABS’) rather than by a
corporate credit’.272 Put it simply, this structured finance transaction involves the selling of assets (for example
housing mortgages or consumer receivables) by their owner (originator) to a new special purpose vehicle
(‘SPV’) which will fund the purchase of the assets by the issuance of ABS to capital markets` investors.273 In
relation to the purchase of the securities by the investors, credit rating agencies (‘CRA’) will rate the bonds in
accordance with their risk assessment.274 On this basis, considerable importance is normally given to the
quality of the asset portfolio that underlines the securities, since the proceeds derived from the receivables are
the ones that will pay interests and principal of the bonds.275 In this way, in order to provide a degree of safety
to investors, one of the most important risk mitigators is the undertaking of careful due diligence of the portfolio,
including commercial matters (potential occurrence of debtors` default) and legal concerns (good title of the
receivables).276 Therefore, securitisation provides benefits for both the originator who accesses new sources
of financing and for the investors who can purchase high rated securities by CRA.277
Recognised the main features of securitisation, it seems pertinent to explain the arguments that
confirm the contribution of this practice to the Crisis. During the years before the Crisis, the securitisation
industry was experiencing a moment of bonanza with many investors purchasing high rated products backed
by housing mortgages.278 However, as already discussed by many commentators, these complex securities
seem to have been overvalued by CRA, since a significant amount of them were, actually, underlined by
subprime mortgages, assets with poor cash flow performance and high risk of default.279 This circumstance
has subsequently resulted in the downgrade of the bonds with the decrease in their performance280 and
damages to investors who purchased these securities. For these reasons, the complex framework of
271 See Rosa M. Lastra and Geoffrey Wood, ‘The Crisis of 2007-09: Nature, Causes, and Reactions’ (2010) Volume 13 Issue 3 Journal of International Economic Law 16. 272 See Marke Raines and Fanny Lau, ‘UK Securitisation’ Volume 1 Number 2 Bankers` Law 23. 273 See Philip Wood, Law and Practice of International Finance (Sweet & Maxwell Limited, 2008) 450-454. 274 See Andrew Mcknight, The Law of International Finance (OUP, 2008) 699. 275 ibid; see Wood (n 43) 450. 276 ibid. 277 See Wood (n 43) 450-456. 278 See Orkun Akseli, ‘Securitisation, the Financial Crisis and the Need for Effective Risk Retention’ (2013) European Organization Law Review 14 7-9; and International Monetary Fund, ‘Securitization: Lessons Learned and the Road Ahead’ (2013) 8-9 available at <https://www.imf.org/en/Publications/WP/Issues/2016/12/31/Securitization-Lessons-Learned-and-the-Road-Ahead-41153> accessed 19 June 2018. 279 See Merritt B. Fox, ‘Due Diligence with Residential Mortgage Backed Securities’ (2013) Columbia Law School Working Paper No 462 60 available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2359679> accessed 19 June 2018; and Kenneth E. Scott and John Taylor, ‘Why Toxic Assets Are so Hard to Clean Up’ (The Wall Street Journal, 21 July 2009) available at <https://www.wsj.com/articles/SB124804469056163533> accessed 19 June 2018. 280 See SEC, ‘Summary Report of Issues Identified in the Commission Staff’s Examination of Select Credit Rating Agencies’ (2008) 2 available at <https://www.sec.gov/news/studies/2008/craexamination070808.pdf> accessed 19 June 2018.
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securitisation is commonly blamed to have played the most important role to the Crisis, however, as supported
by some commentators, securitisation could be considered a ‘causa proxima’ of the Crisis, but not the
exclusive cause of the Crisis.281 On this account, the analysis which supports securitisation as a ‘causa
proxima’ of the Crisis seems to be mostly based on a relevant flaw identified in the securitisation framework:
the overreliance by investors on CRA` ratings in place of the conduction of effective due diligence of the
underlying assets.282
As above mentioned, the Crisis has highlighted a lack of proper due diligence of the pool of
assets securitised by investors who have purchased the products on the exclusive reliance on CRA` ratings283
(which proved to be contestable in subsequent time). 284 However, it appears crucial to mention that
undertaking proper due diligence was not a simple procedure. This is because, there were significant
difficulties related to the quantity and the content of the information of the assets securitised which were
available to investors.285 Firstly, the amount of data available to investors, as provided by the issuers of the
securities in accordance with regulatory requirements, seemed not to be sufficient to correctly understand the
risks of the pool of assets (and in many cases was almost impossible to obtain).286 Moreover, the data, in
some circumstances, was not reliable, since a significant amount of the underlying assets` documentation
omitted information of the debtors` conditions or was based on false statements.287 In this way, it could be
observed that this problematic issue might have its grounds on the structure of the housing mortgage industry
where originators maintained (and still maintains) most of the mortgage documentation on paper and, as a
consequence, could have contributed to the due diligence failures.288
Therefore, the Crisis seems to have clarified a considerable inefficiency in the securitisation process
linked to the lack of proper disclosure and transparency to investors which may have damaged the risk
assessment of the underlying assets by investors. With this respect, in addition to the difficulties liked to due
diligence procedures, there are commentators who argue that the inherent complexity of a securitisation
transaction may also bring difficulties to effectively assess the risks of the transactions.289 Following this
argument, the complex structure involved in these bonds might consequently decrease a desirable level of
transparency to investors.290 Hence, considering the failures in due diligence procedures and the consequent
lack of transparency related to information, it seems that investors remained with little option rather than to rely
on the CRA.291 In response to this circumstance, regulators in different jurisdictions have addressed many of
these issues by imposing new rules to strengthen due diligence and information disclosure requirements of
ABS.292 In the United States, the Dodd-Frank Act has suffered significant statutory reforms and the American
281 See Lastra and Wood (n 41) 16-17. 282 ibid. 283 See Rosa M. Lastra, International Financial and Monetary Law (2th edn, OUP, 2015) 190. 284 See SEC (n 50) 2. 285 See Fox (n 49) 60-64. 286 ibid. 287 ibid. 288 See Deloitte, SFIG and CDC (n 11) 10. 289 See Steven L. Schwarcz, ‘Disclosure`s Failure in the Subprime Mortgage Crisis’ (2008) Utah Law Review 1113-1114. 290 ibid. 291 See Cohen, Samuelson and Katz (n 8) 53. 292 See Fox (n 49) 72.
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Securities Exchange Commission (‘SEC’) has issued new rules to enhance the provision of data related to
ABS to investors.293 On this point, there are commentators who support that the disclosure requirements
imposed by the current regulation have, in fact, improved transparency to ABS` investors, however, they also
argue that this level of information might not be still sufficient to empower investors with an optimal degree of
information to consider risks of these bonds.294 Following this circumstance, it has been considered that
technologies as DLT might be viewed as an allied to address these issues that may still hinder the complete
recovery of the securitisation industry after the Crisis.295 Hence, this paper advocates for this potential
application and argues that DLT could be a promising tool to enhance transparency in the ABS market as will
be further discussed.
2.2. Securitisation and DLT: A New Hope for the Industry?
Considering the deficiencies in the securitisation process, this paper aims to suggest that DLT
may have the potential to deal with these failures, bringing significant benefits to this industry. In this sense, it
could be argued that DLT provides an environment where digitalised data would be commonly available to
their participants and, as a consequence, potentially solve the pitfalls within a securitisation transaction.296
To better explain this, through the storage of the underlying assets and all relevant information related to ABS
on a DLT platform, investors would have the possibility to directly access reliable information, enhancing their
assessment of risks and the conduction of proper due diligence and, therefore, reducing the necessity to
exclusively rely on CRA.297 In order to sustain the proposed assumption, it appears relevant to mention that
this industry is currently considering the use of DLT to improve the structuring of ABS. In this way, important
to mention the work of the Structured Finance Industry Group, one of the main global institutions that aims to
strengthen the securitisation market,298 which has already considered the improvements that DLT could bring
to the whole securitisation process.299 For instance, this institution has supported that DLT and smart
contracts enable a ‘chronological and immutable audit trail of all transactions’.300 In this way, the information
related to the pool of assets virtually stored on a blockchain would be uniform, reliable and accessible to
investors who participate in the network, avoiding problems derived from the content of information and
increasing transparency in this framework.301 However, in order to clearly understand the benefits that DLT
could bring, the paper will briefly explain how this technology could be applied to the entire process of
structuring ABS.
Considering the new framework proposed by this paper, DLT may have the potential to change
all the relevant stages of securitisation, such as: (1) origination of the pool of assets; (2) structuring the
293 ibid 72-73. 294 See Cohen, Samuelson and Katz (n 8) 53. 295 See generally Deloitte, SFIG and CDC (n 11). 296 See Cohen, Samuelson and Katz (n 8) 53. 297 ibid. 298 See SFIG, ‘SFIG´s website’ <http://www.sfindustry.org/about> accessed 20 June 2018. 299 See generally Deloitte, SFIG and CDC (n 11). 300 ibid 8. 301 ibid.
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securities; and (3) monitoring and trading.302 In the first stage, using the most known example of the
securitisation of housing mortgages, it can be noticed that the conclusion of a mortgage loan still may involve
a significant amount of time and is mostly based on huge amount of papers, which could increase the possibility
of errors with the information and also bring costs to access the data.303 Thus, it is suggested that DLT,
through the use of smart contracts, would enable that assets, such as real estate mortgages, to be digitalised
and registered on a DLT`s platform.304 In this scenario, all the relevant data concerned to these assets could
be directly and easily accessible by all the parties of a securitisation transaction, such as originators, services,
CRA and the proper investors.305 Given this context, it could be claimed that this new feature within
registration might provide a higher degree of transparency and safety to investors in case of structuring ABS
underlined by assets recorded on a blockchain. This is because ABS` investors could participate in this
blockchain network and thus have straight access to reliable information, since, once stored on a DLT`s
platform, data is digital identified and immutable (with all the historical chronology and current status of the
asset), reducing the risks of errors or fraud within the assets` documentation.306 Thus, this paper proposes
that DLT could facilitate the process of due diligence (reduction of time and costs) by offering a tool that could
empower investors with ‘accurate, real-time loan-level data about the assets compromising the relevant
pool’,307 and consequently avoiding the need to exclusively rely on CRA` assessment. Furthermore, this tool
could also bring efficiency to the structuring procedure of the securities by making the compliance with
regulation simpler.308 To exemplify this, once the assets are shared to the participants of the network, ABS
could have their underlying receivables previously selected automatically in accordance with regulatory
requisites.309
To complement the benefits above indicated, DLT and, especially, smart contracts might also
provide advantages to the monitoring and trading of ABS. On this account, it has been claimed that the use of
smart contracts could provide automation to the process of monitoring the performance of the ABS and their
respective underlying assets.310 That is to say that, due to the automated execution of smart contracts, they
can report ABS` investors with real-time information of the underlying portfolio, such as due payments or
eventual debtors` defaults.311 For instance, in case of any non-payments by borrowers or the non-compliance
by the issuer of specific obligations of the documentation, investors would be immediately informed by smart
contracts, which could, consequently, lessen the importance of trustees or servicers.312 In this way, investors
302 See Lewis R. Cohen and David C. Tyler, ‘Blockchain´s three capital markets innovations explained’ (Lexology, 15 July 2016) <https://www.lexology.com/library/detail.aspx?g=4d290bb0-6b6f-4868-8b49-92838a755b57> accessed 20 June 2018. 303 See Alex Lielacher, ‘How Blockchain can Disrupt the Mortgage Market’ (Nasdaq, 21 September 2017) <https://www.nasdaq.com/article/how-blockchains-can-disrupt-the-mortgage-market-cm848889> accessed 20 June 2018. 304 See Deloitte, SFIG and CDC (n 11) 11. 305 See Jennifer Hongbo, ‘How much does trust cost?: Analysis of the Consensus Mechanism of Distributed Ledger Technology and Use-Cases in Securitization’ (2017) Sloan School of Management 38 available at <https://dspace.mit.edu/handle/1721.1/111454> accessed 20 June 2018. 306 See Deloitte, SFIG and CDC (n 11) 11. 307 See Cohen and Tyler (n 72). 308 See Deloitte, SFIG and CDC (n 11) 14-15. 309 ibid. 310 Ivan Zone, ‘Loan Securitization Using Smart Contracts’ (Medium, 28 February 2018), available at <https://medium.com/@_ivan_zone/loan-securitization-using-smart-contracts-34cc7a146914> accessed 21 June 2018. 311 See Deloitte, SFIG and CDC (n 11) 17. 312 See Cohen and Tyler (n 72).
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may gain a proper tool to better monitor the performance of the underlying assets, a kind of innovation that
could have been useful during the Crisis in order to efficiently track the payments of the ABS. Finally, it is
suggested that DLT could be also used in the trading of the ABS. To support this proposition, recognised
institutions as the Australian Securities Exchange,313 JPMorgan Chase, Credit Suisse, BNP Paribas, and
Citigroup314 are currently considering the development of DLT-based clearing and settlement systems to
trade securities which may have the potential to decrease the role and costs with intermediaries and, at the
same time, increase transparency and price accuracy.315
Thus, it seems convenient to propose that DLT and smart contracts could, in fact, empower investors
with useful tools to improve all the stages of the securitisation procedure. In this sense, this paper argues that
there is a strong case for the use of DLT within securitisation. This is especially because this technology may
have the potential to increase transparency, safety and efficiency of ABS transactions,316 providing investors
with access to reliable information, diminishing the importance of CRA and, as a result, addressing some of
the weaknesses identified during the Crisis. However, it seems that legal issues remain as one of the main
obstacles to the application of DLT to securitisation. For instance, the law governing smart contracts,
considerations about data security and privacy are just a few examples of legal concerns that commentators
highlight.317 That said, this paper aims to specifically address a relevant legal challenge to the use of DLT in
financial transactions as securitisation: the current regulatory uncertainty in relation to this framework.
Considering the dichotomy between regulation and innovation, this paper will provide a critical analysis of the
approaches that could be taken by regulators to deal with this innovation as will be further discussed.
313 See David Floyd, ‘ASX Exchange Targets 2020 for DLT Settlement System’ (Coindesk, 21 September 2017) available at <https://www.coindesk.com/australian-securities-exchange-eyes-end-2020-dlt-rollout/> accessed 21 June 2018. 314 See Maria Terekhova, ‘Bank behemoths test distributed ledger technology solution for equity swaps’ (Business Insider, 22 November 2017) available at <http://uk.businessinsider.com/jpmorgan-citi-credit-suisse-test-distributed-ledger-technology-solution-2017-11?r=US&IR=T> accessed 21 June 2018. 315 See Deloitte, SFIG and CDC (n 11) 18. 316 ibid 8. 317 ibid 20-21.
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Section 3 – Regulators and their Approaches to Financial Innovation
3.1. Regulatory Uncertainty: A Challenge to be Addressed
Within the current framework of DLT and its relation with the law, regulatory uncertainty is
considered to be a significant obstruction to allow the use of DLT in financial transactions as asset
securitisation. 318 That is to say, given the absence of a clear consistent regulatory framework that
comprehends DLT and financial activities, questions about the acceptance of this technology by regulators
and, especially, how they will treat this potential use, whether, for example, by the issuance of new regulation,
or by applying current legislation.319 In this sense, there are commentators who argue that the mentioned
indecision by regulators could in fact harm or stifle the potential use of DLT in financial services.320 They
consider that current regulation might be ill-suited to address new legal circumstances brought by DLT and,
therefore, firms that develop DLT` solutions could be uncertain about which laws are applied or if regulators
will indeed accept it.321 In addition, regulatory uncertainty may also lead to ‘negative externalities’, since firms
that aim to apply DLT to their business could have increased burden expenses in order to clearly define their
legal status.322 As DLT is a technology in a beginning stage, regulators are still analysing the best legal
strategy to embrace this technology, adopting different approaches to deal with it in many jurisdictions.323
While in countries like Switzerland, regulators tend to promote an innovation-friendly environment, being
currently opened to embrace DLT within financial markets, other regulators in countries as Brazil are still
treating innovations as DLT and virtual currencies with cautious.324 In this way, it could be argued that this
divergent framework among national jurisdictions could bring difficulties to innovative firms to observe each
national approach (which may vary in their severity) and, as result, harming the development of innovations
as the use of DLT in securitisation.325 Therefore, regulatory uncertainty remains as a significant obstacle to
the application of DLT to financial activities as securitisation, since, in order to allow the use of this technology
in financial practice, regulators will have to embrace it by providing an adequate regulatory strategy. However,
to fully consider the allowance of this innovative proposal, it seems crucial to reflect on the approaches that
could be taken by regulators to deal with financial innovation, leading this paper to the recurring discussion
linked to the relationship between regulation and innovation.
Law and regulators are continuously ‘running’ to address technological innovations that may
arise in the market.326 In this context, it seems clear that innovations as DLT could bring relevant benefits to
318 See Primm (n 13) 84-85. 319 See Deloitte, SFIG and CDC (n 11) 21; and generally Finck (n 20). 320 See Primm (n 13) 84-85. 321 ibid. 322 See Finck (n 20) 21. 323 ibid 11; see Chris Brummer & Yesha Yadav, ‘Fintech and the Innovation Trilemma’ (2017) Georgetown Law Journal, 2018 Forthcoming 44, available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3054770> accessed 21 June 2018. 324 See Alvaro Rivero, ‘Distributed Ledger Technology and Token Offering Regulation’ (2018) available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3134428>; see also Reuters Staff, ‘Brazil regulator bans funds from buying cryptocurrencies’ (Reuters, 12 January 2018), available at <https://www.reuters.com/article/brazil-bitcoin/brazil-regulator-bans-funds-from-buying-cryptocurrencies-idUSL1N1P71DV> accessed 24 June 2018. 325 See Brummer & Yadav (n 93) 60-61. 326 See Lyria Bennett Moses, ‘Agents of Change: How the Law Copes with Technological Change’ (2011) 20 Griffith Law Review 763.
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the financial practice. For instance, legal scholars constantly claim that financial innovation can be historically
seen as an accelerator of financial markets and the economy as a whole.327 These improvements are mostly
related to the capability of financial innovation to potentially increase efficiency and minimise costs of
transactions, as well to address recurrent market problems (for example, lack of transparency that might harm
investors` investment decision).328 On this basis, it could be argued that the use of a DLT platform in the
securitisation process might be considered an example of financial innovation improving market efficiency. On
the other hand, legal academy also teaches that financial innovation may also be the genesis of risks and
harmful circumstances, such as was observed during the Crisis with the proper structured finance industry.329
Considering the above mentioned, in order to respond to problematic issues derived from financial
innovation (for example, new forms of risks), a recurrent approach taken by regulators is to strengthen the
regulatory oversight to financial innovation.330 Nevertheless, strictly regulating financial innovation might, at
the same time, hinder its development due to the increased burdens that intrusive regulation could bring.331
To clarify this, it is constantly claimed that there is a clear trade-off between regulation and innovation, since,
when focusing on providing strict regulation, regulators may restrain innovative tools as DLT.332 On the
opposite, by taking a more permissive approach to financial innovation, regulators could threat the integrity of
the market considering eventual risks derived from new financial tools,333 and, consequently compromising
the objectives of financial regulation. Following this stance, Christine Lagarde, managing director of the
International Monetary Fund (‘IMF’), has already highlighted the importance of defining a suitable regulatory
approach to Fintech innovations, as well as the difficulties to achieve this aim.334 The director claims that
regulators must find an adequate approach that preserves innovation without its restraint and, at the same
time, meets the objectives of regulation as investor protection and market integrity.335 Thus, it seems clear
the importance of regulators to address eventual regulatory uncertainty related to DLT and financial
transactions with an appropriate regulatory model that should face this issue by not compromising innovation
or the objectives of financial regulation. On this account, in order to propose this suitable approach to address
regulatory uncertainty that hinders the application of DLT to financial activities as securitisation, this paper will
provide a critical analysis of the possible strategies conducted by regulators that could be used to deal with
this new framework.
327 See Emilios Avgouleas, ‘Regulating Financial Innovation’ in Niamh Moloney, Eilis Ferran and Jennifer Payne (eds), The Oxford Handbook of Financial Regulation (1th edn, OUP, 2015) 667. 328 See Dirk A. Zetzsche, Ross P. Buckley, Douglas W. Arner and Janos Nathan Barberis, ‘Regulating a Revolution: From Regulatory Sandboxes to Smart Regulation’ (2017) Fordham Journal of Corporate and Financial Law 6. 329 Zetzsche and others (n 98) 6 emphasize that new kinds of derivatives products like Collateral Debt Obligations and Credit Default Swaps were relevant to the rise of the problems observed during the Crisis. 330 See Brummer & Yadav (n 93) 26-27. 331 ibid. 332 ibid 6. 333 ibid. 334 See Christine Lagarde, ‘A Regulatory Approach to Fintech’ (2018) Finance and Development 9-10. 335 ibid.
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3.2. Regulation and DLT: Possible Approaches by Regulators
In light of the above discussed, it seems that regulatory uncertainty persists as a difficult barrier to
allow the use of DLT in securitisation, especially considering the difficulties to define an approach that properly
embrace this innovation. Therefore, providing a critical evaluation of the approaches that could be taken by
regulators appears as a crucial task for the purpose of this paper. Therefore, in the following part, this research
will examine the regulatory strategies normally used by regulators when facing financial innovations like DLT:
(i) the Wait and See Approach, and (ii) the Issuance of New Regulation.
3.2.1. Wait and See Approach
In order to address the regulatory uncertainty challenge to the use of DLT in financial activities
as securitisation, one possible approach that could be taken by regulators is the commonly known ‘Wait and
See’336 approach (‘Wait and See Approach’). This regulatory strategy is popular within regulators and
supported by some academics in view of specific benefits that it could bring to the development of financial
innovation.337 To put it simply, the Wait and See Approach is based on the use by authorities of existing laws
to deal with financial innovation without the issuance of new regulation that could suppress the development
of this technology by bringing new costs to firms.338 Therefore, this seems to clarify the clear advantages of
this approach and the reasons why some regulators adopt it to deal with DLT.339 There are commentators
who support that the Wait and See Approach might provide time to the industry to develop DLT solutions (as
its use in securitisation) without difficulties derived from new regulation, while, at the same time, allow
regulators to learn more about this innovation.340 For these reasons, this approach is commonly based on
the assumption of ‘educate, don’t regulate’,341 since regulators may have a period to engage with the industry
to better understand the complex framework of DLT and effectively assess the necessity or not to provide new
laws, allowing this innovation to flourish.342 Thus, it appears that the Wait and See Approach is being widely
used to deal with DLT. For instance, this is the strategy taken by the European Securities and Markets Authority
(‘ESMA’), which has already recognised that DLT may improve securities transactions, however, the body
understands that it seems early to consider a new regulatory framework to this technology, emphasizing that
current EU laws could attend its initial use in financial transactions.343 To reinforce the arguments of the
proponents of the Wait and See Approach, it could also be effective to provide a parallel with the strategies
concerned with virtual currencies. On this point, there is a current tendency by regulators to adopt a Wait and
See Approach in dealing with the issuance of virtual currencies, applying prevailing laws to these emissions
336 See Finck (20) 12. 337 ibid; see Douglas W. Arner, Jànos Barberis and Ross P. Buckley, ‘The Evolution of Fintech A New Post-Crisis Paradigm?’ (2015) University of Hong Kong Faculty of Law Research Paper No 2015/047 33, <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2676553> accessed 24 June 2018. 338 See Finck (20) 12. 339 See Osborne Clarke, ‘An introduction to Blockchain: the key legal issues’ (11 August 2017), available at <http://www.osborneclarke.com/insights/an-introduction-to-blockchain-the-key-legal-issues/> accessed 12 July 2018. 340 See Finck (20) 12. 341 ibid. 342 ibid. 343 See generally ESMA, ‘Report the Distributed Ledger Technology Applied to Securities Markets’ (2017), <https://www.esma.europa.eu/system/files_force/library/dlt_report_-_esma50-1121423017-285.pdf> accessed 12 July 2018.
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and, as a result, not harming the development of these innovative products.344 In this way, the SEC is
currently aligned with this tendency, since the American regulator is applying the provisions of the Securities
Exchange Act 1934 to certain emissions of virtual currencies.345
Despite the above presented, one may argue that a Wait and See Approach might fail to entirely
address regulatory uncertainty, since, in order to define which existing laws are applied to DLT`s innovations,
legally defining this technology can be a barrier to this strategy.346 In other words, it seems that, until there is
a clear legal definition of the technology and by which regulation it is submitted, firms that aim to implement
DLT to securitisation might be restricted due to the lack of certainty of which laws to observe.347 Hence, one
possible solution to this issue is to complement the Wait and See Approach with the provision of informal
guidance by regulators.348 This means that regulators might informally express their view of which laws
should be applied to innovations in the markets (as the case of DLT) without the issue of new formal
regulation.349 Therefore, the arguments previously indicated could sustain this strategy to deal with DLT`s
solutions to securitisation and, in this way, address the discussed regulatory uncertainty challenge.
Nevertheless, this paper identifies some failures in the pure application of the Wait and See Approach which
might undermine its use.
In spite of the arguments above presented, this paper contests the use of a Wait and See Approach,
arguing that the exclusive application of this strategy could not be suitable to address the regulatory uncertainty
challenge that hinders DLT and ABS transactions. This assumption stems from the following arguments: (i) a
remaining lack of legal certainty; and (ii) the timing related to this approach. With respect to the first argument,
it can be observed that the Wait and See Approach might indeed not harm the development of DLT`s
innovations, however, it seems reasonable to argue that it may fail to entirely provide a high degree of legal
certainty. To support this statement, it could be argued that existing regulation might be ill-suited to address
all the new legal issues brought by DLT or, even if they fully achieve the DLT framework, laws are in constant
change and may rapidly become outdated, which might demand that regulation ‘to be adapted, or that entirely
new laws will need to be implemented, to cater for blockchain’.350 Furthermore, as previously indicated, the
lack of a legal classification in relation to DLT, as well as the inexistence of a clear legal framework could harm
innovators with legal uncertainty.351 As above observed, there are commentators who advocate for the use
of informal guidance as a way to provide legal certainty to innovators.352 However, it is argued by this paper
that informal guidance might not entirely solve this problem. As these statements are not empowered with
344 See Rosa M. Lastra and Jason G. Allen, ‘Virtual Currencies in the Eurosystem: challenges ahead’ (2018) European Parliament Monetary Dialogue 32-33, available at <http://www.sipotra.it/wp-content/uploads/2018/07/Virtual-currencies-in-the-Eurosystem-challenges-ahead.pdf> accessed 12 July 2018. 345 See SEC, ‘SEC Issues Investigate Report Concluding DAO Tokens, a Digital Asset, were Securities’ (25 July 2017), <https://www.sec.gov/news/press-release/2017-131> accessed 12 July 2018, where the regulator states that some virtual currencies could be classified as securities and therefore subjected to securities laws. 346 See Finck (20) 13. 347 ibid. 348 See Brummer & Yesha Yadav (n 93) 44. 349 See Finck (20) 13. 350 See Osborne Clarke (n 109). 351 See Finck (20) 13; and Primm (n 13) 84-85. 352 See Brummer & Yesha Yadav (n 93) 44.
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binding effects, courts could have the prerogative to dismiss these informal instructions and, as result, firms
that wish to create DLT` solutions to securitisation could still have concerns related to which laws to observe
(i.e. legal uncertainty).353 In relation to the second argument, timing could also be seen as a disadvantage of
the Wait and See Approach. Regulators may take considerable time with the referred approach to better
understand DLT` proposals, without providing a clear new legal framework to the industry.354 During this time,
DLT may quickly grow (as normally grow technologies) and creates eventual new circumstances and risks not
foreseen by existing laws,355 remaining innovators with incompatible regulations. For these reasons, this
paper argues that regulators applying an isolated Wait and See Approach seem not to be considered the most
suitable regulatory response to the application of DLT to securitisation, especially given its failure to entirely
provide legal certainty and the length of time that it could take. Following these arguments, it could be
recognised the incapacity of the pure use of the Wait and See Approach to properly cope with DLT and financial
activities as securitisation, which could therefore lead to the support of a different approach to face regulatory
uncertainty: the issuance of new regulation.356
3.2.2. Issuance of New Regulation
Taking into account the argued flaws of a sole Wait and See Approach to cover the potential
application of DLT to securitisation, one strategy that could be conducted by regulators is to issue new
legislation that would specifically address DLT.357 In this sense, there are supporters who advocate for the
necessary enactment of specific regulation in order to allow financial transactions to be performed on a DLT
platform.358 On the basis of this proposition, it appears that this could be the same interpretation given to the
case of DLT and securitisation, since, to securitise assets recorded on a blockchain or issue ABS in a DLT
platform, regulators would have to address this issue by separate new regulation. Following this proposal, it
appears relevant to briefly bring into the consideration the goals of financial regulation.
In order to comprehend if a regulatory strategy is indeed suitable (including, their suitability to deal
with financial innovation), there are commentators who highlight the importance of clearly defining the
objectives of financial regulation.359 In this way, they consider the following goals of financial regulation: (i)
investors protection; (ii) retail investor protection; (iii) safeguard of financial stability; (iv) safeguard of market
efficiency; (v) market competition; and (vi) prevention of financial crime.360 That said, given the goals of
investors protection and financial stability, they are deemed to be critical concerns by regulators, since financial
regulation is essential to protect investors from fraudulent practices, to avoid them to take disproportionate
353 Concerning the dismissal by courts of informal guidelines, see Finck (20) 14 who observes that ‘this happened in the context of the platform economy where the European Court of Justice`s Advocate General Szpunar has been unimpressed by the European Commission`s guidelines on whether a platform should be considered as a mere intermediary or as also providing the underlying service’. 354 See Dr. Julie A. Maupin, ‘Mapping the Global Legal Landscape of Blockchain and other Distributed Ledger Technologies’ (2017) 6, available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2930077> accessed 13 July 2018. 355 ibid. 356 See Paech (37) 25-26. 357 See Finck (20) 16. 358 See generally Paech (37). 359 See John Armour and others, Principles of Financial Regulation (OUP, 2016) 61. 360 ibid 61-69.
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risks and to guarantee the stability of the system.361 In this regard, it is widely argued that the use of DLT to
store or trade assets (as in the proposed case of securitisation) may pose significant threat to financial
stability.362 There are commentators who sustain that, as DLT is based on virtually and interconnected
platforms between their participants, financial transactions stored on a blockchain, if reach an expressive
amount of value or participants in this network, might have the potential to be a risk to the stability of the
system.363 Following this assumption, due to existing borders between digital platforms and the real markets,
problems in the digital environment can be expanded and spread to many institutions, eventually harming the
financial system as a whole.364 Therefore, these circumstances may legitimate the regulation of DLT as a
way to ensure financial stability and investors protection (i.e. objectives of financial regulation).
Complementing the arguments that may endorse the issuance of new rules to DLT` proposals, one
may also argue that this approach might also provide legal certainty to innovators that seek to implement DLT
to their financial activities.365 To put it simply, the referred proposition states that, by providing a clear legal
framework to DLT, regulated participants of the market could safely know which rules are applied to their DLT`s
experimentations and, as a result, reduce the costs by innovators with regulatory compliance.366 In this
context, it seems that regulators that take this kind of approach aim to create an authentic ‘blockchain-friendly
venue’367 and, therefore, be attractive to firms that wish to innovate with DLT.368 For example, it could be
cited the cases of Gibraltar and Malta. In the first case, the Gibraltar Financial Services Commission has
recently issued the Financial Services (Distributed Ledger Technology Providers) Regulations 2017,369 a
legislation that establishes a specific DLT framework for firms that seek to use DLT into their activities.370
Secondly, the Malta Digital Innovation Authority Act, the Innovative Technological Arrangement and the Virtual
Financial Assets Bill are recent laws designed by Maltese authorities that cover the regulation of DLT and
virtual currencies.371 By enacting this new legislation, it seems that the Maltese regulator intends to create a
regulatory framework which will encourage the development of innovations and achieve the goals of financial
regulation (such as financial stability and investors protection).372 Therefore, according to the arguments of
this proposition, the use of DLT in securitisation should be dealt by regulators with the issuance of new
legislation to embrace this framework. However, even though there are clear benefits that regulation may bring,
this paper questions some issues related to the adoption of this approach, especially due to its inefficiency to
adequately address the trade-off between regulation and innovation.
361 ibid 62-65. 362 See Paech (37) 16. 363 ibid 17. 364 See Lastra and Allen (n 114) 32-33. 365 See Finck (20) 16-17. 366 ibid 16; see Nathan Cortez, ‘Regulating Disruptive Innovation’ (2014) Berkeley Technology Law Journal Volume 29 Issue 1 203-204. 367 See Finck (20) 17. 368 ibid. 369 See Gibraltar Gazette No 4401 12 October 2017. 370 See Gibraltar Financial Services Commission, ‘Distributed Ledger Technology Regulatory Framework (DLT Framework)’, <http://www.gfsc.gi/dlt> accessed 17 July 2018. 371 See Ana Alexandre, ‘Malta Passes Blockchain Bills Into Law, ‘Confirming Malta as the Blockchain Island (Cointelegraph, 05 July 2018), <https://cointelegraph.com/news/malta-passes-blockchain-bills-into-law-confirming-malta-as-the-blockchain-island> accessed 17 July 2018. 372 See Lastra and Allen (n 114) 27.
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Despite the advantages of new DLT regulation, this paper identifies some flaws in this approach,
since the content of new rules could be seen as a barrier that may refrain DLT. In this way, distinguished
academics as Charles Goodhart have already pointed out the downsides that detailed regulation may create,
such as imposing firms more expensive forms to comply with rules and, therefore, harming the development
of innovation.373 This means that new regulation might have the risk to be highly complex or rigorous and
impose new costs on firms that could stifle the implementation of DLT to securitisation.374 With this respect,
it has been argued that, in order to comply with strict requirements established by new laws, firms (especially
small sized ones) may have their costs significantly increased and, as a result, inhibiting the development of
DLT proposals to financial practices.375 Thus, this paper claims that new regulation to DLT could have the
adverse effect of refraining this technology by imposing new expenses to innovators and, therefore, might not
fully observe the trade-off between regulation and innovation. This is because, on one side, it could attend the
objectives of financial regulation, however, on the other side, the content of regulation can impose highly
complex and burdensome requirements that might undermine the development of DLT` solutions to financial
markets.376
Reinforcing the above argued, it seems that the time that regulators establish new rules also
appears as a relevant issue to be considered in order to analyse the convenience of the discussed regulatory
approach. To put it simply, premature regulation could also have the negative result of harming the financial
innovation.377 For this reason, the timing that authorities legislate new activities (as the use of DLT in
securitisation) might be essential to preserve innovation. In this context, it has been claimed that premature
regulation of financial innovation ‘may quickly be avoided or become obsolete’,378 since, at an initial stage of
a technology, regulators tend to fail to comprehend all the risks that could be derived from an innovation,379
or if the financial markets will indeed embrace it,380 which may entail on early ill-suited laws. In relation to
DLT and its use in financial transactions, it has been considered that this technology is still not entirely tested,
therefore, innovators and regulators are monitoring and understanding its potential use to financial
activities.381 In this way, it is argued by this paper that the issuance of specific DLT regulation, at the present
moment, seems not to be the most suitable approach to be taken in order to address the regulatory uncertainty
challenge to allow the application of DLT to securitisation, especially considering its early stage of development.
To sustain this, it could be cited the successful case of e-banking, an activity that began to be developed a
significant time before its regulation, which might have resulted in the positive outcomes within this industry.382
373 See Charles Goodhart and others, Financial Regulation Why, how and where now? (Routledge, 1998) 2. 374 See Jacques Pelkmans and Andrea Renda, ‘Does EU Regulation Hinder or Stimulate Innovation?’ (2014) CEPS Special Report No 96 10-11, available at <https://www.ceps.eu/system/files/No%2096%20EU%20Legislation%20and%20Innovation.pdf> accessed 17 July 2018. 375 ibid; see Finck (20) 18. 376 ibid. 377 ibid. 378 See Iris H-Y Chiu, ‘A Rational Regulatory Strategy for Governing Financial Innovation’ (2017) European Journal of Risk Regulation, Forthcoming 758 available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3032712> accessed 17 July 2018. 379 ibid. 380 See Arner, Barberis and Buckley (n 107) 32. 381 See Deloitte, SFIG and CDC (n 11) 21; and ESMA (n 113) 18. 382 See Arner, Barberis and Buckley (n 107) 32.
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Hence, given the arguments above presented, this regulatory strategy might have the risk to stifle DLT (not
attending the innovation-regulation trade-off) and to provide premature and ineffective rules by virtue of the
necessity to confirm its actual embracement by the market and to clarify the exact legal issues that regulators
may have to address in prospective legislation.
Therefore, until this point, this paper has provided an analysis of the possible approaches that
regulators may take to address the regulatory uncertainty challenge in order to allow the application of DLT to
securitisation. Considering this examination, it seems that both the Wait and See Approach and the issuance
of new regulation may bring benefits to the DLT framework, however, this paper identifies flaws in these
strategies that undermine their use by regulators to cover DLT and securitisation. Recognised this statement,
the research will subsequently provide the legal arguments that could support the embracement by regulators
of DLT and securitisation and, finally, will propose a convenient regulatory approach to properly address this
framework.
SECTION 4 – DLT AND SECURITISATION: ACHIEVING THE AIM OF SECURITIES
LAWS AND A REGULATORY MODEL TO BE FOLLOWED
4.1 Why regulators should embrace DLT and Securitisation?
Before suggesting the most suitable approach to address the discussed regulatory challenge, it seems
critical for the aim of this paper to firstly clarify the legal arguments that could sustain the embracement by
regulators of the application of DLT to the ABS market. As explained in Section 2, securitisation is a kind of
financial transaction that uses a pool of receivables to underline the issuance of securities.383 For this reason,
these financial assets are considered as proper securities and, therefore, their issuances are submitted to the
rules prescribed by securities laws.384 The regulation applied to the issuance of securities is commonly
defined as the legislative material that ‘compromises the regulation of public issuers of securities, secondary
markets, asset management products and market intermediaries’, 385 and has their proper particular
objectives. Among those, investor protection appears as one of the most relevant goals that regulators aim to
achieve with securities laws.386 On this account, scholars as John Armour explain that investor protection is
a rationale which is widely adopted by national securities laws and basically provided by rules of mandatory
disclosure.387 In other words, this academic standing considers that securities laws are mostly based on the
mandatory disclosure by issuers of the relevant information necessary for investors to evaluate the risks
derived from the securities and, therefore, to have the capacity to make an informed investment decision.388
In this way, it seems that securities regulation aims to empower investors with the relevant information to allow
383 See Wood (n 43). 384 See Alastair Hudson, Securities Laws (Sweet & Maxwell, 2008) 14. 385 See International Monetary Fund, ‘Strengths and Weaknesses in Securities Market Regulation Market Regulation: A Global Analysis’ (2007) IMF Working Paper WP/07/259 6 available at <https://www.imf.org/en/Publications/WP/Issues/2016/12/31/Strengths-and-Weaknesses-in-Securities-Market-Regulation-A-Global-Analysis-21428> accessed 17 July 2018. 386 See Armour and others (n 129) 62. 387 ibid. 388 ibid.
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them to conduct a rational analysis before purchasing securities and, as a consequence, to increase
transparency in the market.389 In this context, it should be also highlighted that there are commentators who
question the capacity of investors to deal with an excessive amount of complex information, which may
undermine the role of disclosure to investor protection.390 In spite of these arguments, the current securities
regulation`s framework is still based on a disclosure-regime as supported by the International Organization of
Securities Commissions (‘IOSCO’),391 which prescribes as the objectives of securities laws: ‘the protection of
investors; ensuring that markets are fair, efficient and transparent and the reduction of systemic risk’.392
According to these objectives, the referred organisation emphasises the importance of full disclosure as the
most relevant way for securities laws to provide the protection of investors in capital markets.393 That said, it
could be understood that securities laws have as their aim the provision of investor protection by disclosure of
information, creating a more transparent and safer capital market.
Given the above considered, it seems relevant to observe that this disclosure-based approach was
embraced by current regulation that specifically deals with securitisation. As highlighted in Section 2, the Crisis
has shown considerable flaws in the securitisation stages which seem to have failed in ensuring investors with
relevant information of the ABS.394 Thus, one of the main responses by regulators to face this problematic
circumstance was to strengthen due diligence and disclosure obligations in compliance with the transparency
objective of securities regulation.395 Following this tendency, it could be cited current regulation in the US and
the European Union. In the first case, the commonly known Regulation AB, as amended by Regulation AB II,
is clear with its intention to ‘to provide investors with timely and sufficient information, reduce the likelihood of
undue reliance on credit ratings’396 and, as a consequence, enhance investor protection.397 This law sets
out an array of disclosure requirements to issuers as, for example, the obligations prescribed by item 1111 of
Regulation AB linked to the disclosure of the characteristics of the underlying assets.398 On the same path,
the European Parliament has recently released the Regulation (EU) 2017/2402 which also intends to create
within the European Union`s capital market a ‘specific framework for simple, transparent and standardised
securitisation’,399 imposing new disclosure requirements to allow investors to make informed decisions in the
389 See Luca Enrique and Sergio Gilotta, ‘Disclosure and Financial Markets Regulation’ in Niamh Moloney, Eilis Ferran and Jennifer Payne (eds), The Oxford Handbook of Financial Regulation (1th edn, OUP, 2015) 514-515; and Paul Latimer, ‘Securities Regulation Laws – Their Aims and How to Achieve Them’ (2012) 3, available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2460220> accessed 23 July 2018. 390 For a detailed analysis of the arguments which support the ineffective of the mandatory disclosure system, see the literature of Troy Paredes, ‘Blinded by the Light: Information Overload and its Consequences for Securities Regulation’ (2003) 81 Washington University Law Quarterly forthcoming 417, <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=413180>, accessed 23 July 2018. On this account, the academic suggests that the overload of information problem might be addressed by regulation through the prescription of a higher degree of standardization and less complexity. 391 IOSCO is an international authority that aims to provide standards for global securities laws. See IOSCO, ‘IOSCO´s website’ <https://www.iosco.org/about/?subsection=about_iosco> accessed 23 July 2018. 392 See IOSCO, ‘Objectives and Principles of Securities Regulation’ (2003). 393 ibid. 394 See Fox (n 49) 60-64. 395 See Steven L. Schwarcz, ‘Securitization and Post-Crisis Financial Regulation’ (2016) Cornell Law Review Online 118-121. 396 Asset-Backed Securities Disclosure and Registration, SEC Release Nos. 33-9638, 34-72982, 79 Fed. Reg. 57184 (2014) 16. 397 ibid. 398 Asset-Backed Securities, SEC Release Nos. 33-8518, 34-50905, File No. S7-21-04 (2005). 399 Regulation (EU) 2017/2402 of 12 December 2017.
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securitisation market. 400 That said, it seems that securities regulation mainly aims to provide investor
protection by ensuring a transparent framework based on disclosure obligations as reflected by national laws,
including the ones that address securitisation. Therefore, this paper considers that this assumption might
clarify the reasons for regulators to embrace DLT and securitisation, since the benefits of this technology seem
to match with the objectives of securities laws.
In Section 2, this paper has explored the potential benefits that DLT might bring to securitisation by
functioning as a tool to increase transparency in this market, a new framework that seems to be in line with
the aim of securities regulation. By recording the underlined assets of ABS on a DLT platform, investors could
have direct access to digitalised and more reliable information of the securities before their purchase, as well
as during their entire lifecycle.401 These benefits may indeed increase transparency in the securitisation
process, since investors would be empowered with real-time data and issuers a more efficient platform to
comply with information disclosure requirements imposed by laws.402 Therefore, this assumption clarifies the
legal reasons for regulators to allow the use of DLT in securitisation. This is because, this paper argues that
the increase of reliable information disclosure and transparency among ABS transactions seems to be in line
with the aim of securities laws. To this support this stance, as above clarified, one of the objectives of securities
regulation is to pursue investor protection by mandatory disclosure and consequently to create a more
transparent environment for investors.403 Following this objective, by implementing DLT to securitisation,
regulators might allow the use of a tool that has the potential to create a more informed market and, hence, to
strengthen investors protection as prescribed by securities legislation`s goals. Furthermore, DLT might be also
useful for the regulatory authorities, especially considering the advantages brought by the commonly known
Regulatory Technology (‘Regtech’).404 In this sense, regulators could be given access to the shared DLT
platform, where the underlined assets of a securitisation transaction would be stored and, in this way, they
might be provided with straight monitoring of the performance of the securities, as well as the compliance of
obligations by the parties.405 In the latter suggestion, it is claimed that, at the time of the events of the Crisis,
if regulators had a technology as DLT to monitor the performance of the structured products (identifying the
decrease on the underlined repayments), they might have taken earlier actions to prevent the significant
damages occurred.406
Given the above explained, this paper argues that there is a strong legal case for regulators to allow
the use of DLT in the securitisation framework. To justify this statement, it is claimed that regulators have
consistent legal grounds to embrace DLT and securitisation, since, by doing so, they are complying with the
400 Article 7 of the Regulation (EU) 2017/2402 establishes an extensive list of information that issuers and originators must make available to investors. 401 See generally Deloitte, SFIG and CDC (n 11). 402 ibid 8. 403 See Armour and others (n 129) 62. 404 For the definition of Regtech, see the one proposed by Lastra and Allen (n 114) 48, who define Regtech as ‘the use of new Information and Communications Technology (‘ICT’) in monitoring, reporting and compliance.’ In this sense, Regtech is defined as a framework where technology is used to improve regulatory supervision. 405 See Deloitte, SFIG and CDC (n 11) 5-19. 406 See J. Christopher Giancarlo, ‘Special Address of CFTC Commissioner J. Christopher Giancarlo Before the Depository Trust & Clearing Corporation 2016 Blockchain Symposium’ (US Commodity Futures Trading Commission, 29 March 2016), available at <https://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-13> accessed 26 July 2018.
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objectives of securities regulation (investor protection by market disclosure), ensuring a higher degree of
transparency to the securitisation market.407 As DLT is seen as a tool that could create a more transparent
environment for investors,408 it is argued that the use of this technology meets the aim of securities laws by
enhancing the disclosure of reliable information and, in this way, providing higher protection for investors. In
addition, the benefits that this technology may create to regulators` supervision (the above case of Regtech)
is also considered by this paper as an argument that supports the regulatory allowance of DLT to securitisation.
Hence, this paper sustains the adoption by regulators of this new framework, since this proposal seems to be
in line with the aim of securities regulation. Recognised these legal arguments to support this possibility, this
paper will, at this moment, answer the central question proposed by this research: defining the regulatory
model for regulators to deal with DLT and securitisation.
4.2 Regulatory Sandboxes: A Do no Harm Proposal for DLT and Securitisation
Clarified the reasons why regulators should consider the use of DLT in securitisation, in this
part, this paper suggests a suitable approach to address the current regulatory uncertainty that refrains this
new framework. As previously argued, flaws can be identified in the traditional strategies taken by regulators
in dealing with financial innovation (Wait and See Approach and the issuance of new regulation). Following
this analysis, this paper highlights the ideas proposed by the Chairman of the American Commodity Futures
Trading Commission (‘CFTC’), J. Christopher Giancarlo, who has strongly supported the use of a do no harm
approach by regulators to deal with DLT and its use in financial markets.409 To clarify this, this do no harm
strategy would be based on the assumption that regulators should provide a flexible legal framework that must
not stifle innovation, avoiding strict application of existing or premature new regulation.410 In the words of
Chairman Giancarlo, the principle of the do no harm prescribes that ‘governments and regulators should avoid
undue restrictions, support a predictable, consistent and simple legal environment and respect the bottom-up
nature of the technology and its development in a global marketplace’.411 This seems that this strategy
focuses on providing a clear room for innovation to naturally evolve without burdens derived from new
regulation or ill-suited existing laws. On this path, there are commentators who state that this approach was
successfully used by regulators during the rise of the Internet in the US and it was crucial to its
consolidation.412 It is constantly argued that this do no harm proposal has allowed the Internet to grow,
because it was overseen by a flexible legal framework proposed by regulators which seems to have stimulated
investments in this technology.413 Following this explanation, despite also aiming to do not stifle innovation
407 See Armour and others (n 129) 62. 408 See generally Deloitte, SFIG and CDC (n 11). 409 See Giancarlo (n 176). 410 ibid; see Blummont (n 15) 25-26. 411 ibid. 412 ibid; see Marco Dell’Erba, ‘Initial Coin Offerings. A primer. The first response of regulatory authorities’ (2017) 14-15, available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3063536> accessed 17 July 2018. 413 See Giancarlo (n 176) who strongly emphasizes that, during the governing of this approach, expressive amount of capital was invested in the development of Internet, for instance, ‘investors deployed $90 billion into the cross-continental fiber-optic broadband network, and broadband reached homes and smaller businesses, while large businesses built their own dedicated data connections.’
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and promote its development,414 this paper considers that the mentioned Wait and See Approach appears
not to be completely in line with the concepts of do no harm proposed by Chairman Giancarlo. This is because,
the Wait and See Approach seems to exclusively relies on existing legislation that, in some cases, could be
ill-suited to address DLT`s innovations415 and, therefore, potentially not providing legal certainty (possibly
outlining a less active approach).416 On the other hand, this idea of do no harm proposed by Chairman
Giancarlo additionally comprehends the actual creation by regulators of a clear legal framework based on
‘uniform principles in an effort to encourage DLT investment and innovation’,417 which might succeed in
providing legal certainty to market participants418 (possibly highlighting a more active approach). To better
explain the design of this framework, this paper sustains the case of regulatory sandboxes as an example of
the use by regulators of the do no harm concepts.419
As already stated by some commentators, the creation of regulatory sandboxes could be
considered a proposal in line with the do no harm suggestions proposed by Chairman Giancarlo and, therefore,
a suitable new strategy to deal with the use of DLT in financial transactions as securitisation.420 A regulatory
sandbox is widely defined as an environment created and under supervision by regulators which allows firms
to test their financial innovations (including technologies as DLT) without having to comply with all strict
regulation421 that normally stifles the development of new market products. In other words, a sandbox is a
‘safe space’422 based on the idea of experimentation, where regulators allow firms to test their financial
experiments through the application of specific flexible rules or by the grant of exemptions to comply with the
current regulation.423 To better explain how functions a regulatory sandbox, firms could be allowed to
experiment the structuring of securitisation transactions using DLT inside this space, where they will be
subjected to flexible rules under the regulator`s monitoring.424 In order to avoid risks that could be derived
from the technology and ensure investors protection, during this process, regulators may impose some
conditions to allow these tests inside the sandbox.425 For example, these conditions could comprehend
limitation of time, kind of consumers available to purchase the products and the value of the transactions.426
Once successfully tested, this new product could be carried to the actual financial markets.427 Therefore, this
could be the same approach applied by regulators to DLT and securitisation by experimenting the use of this
technology through the stages of a ABS transaction inside the inside sandbox. Within the testing period,
regulators could confirm the actual benefits that DLT may bring to securitisation, as well the necessity to
414 See Finck (20) 12. 415 See Osborne Clarke (n 109). 416 ibid. 417 See Giancarlo (n 176). 418 ibid. 419 See Blummont (n 15) 26. 420 ibid. 421 See Finck (n 20) 14. 422 See Zetzsche and others (n 98) 26. 423 ibid; see also Finck (n 20) 14; and Brummer & Yadav (n 93) 51. 424 ibid. 425 See Lev Bromberg, Andrew Godwin and Ian Ramsay, ‘Fintech Sandboxes: Achieving a Balance between Regulation and Innovation’ (2017) Journal of Banking and Finance Law and Practice, Vol. 28, No 4 4. 426 See Zetzsche and others (n 98) 3-37, who indicate the conditions normally applied by regulators to firms that participate in sandboxes. 427 ibid.
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change current regulation or to design eventual new laws to properly address this framework.428 At the current
stage, some regulators have already taken the path to create regulatory sandboxes.429 However, it seems
crucial to highlight the case of the United Kingdom regulator, the Financial Conduct Authority (‘FCA’), which
was the pioneer in providing a regulatory sandbox focused on Fintech`s innovations as DLT.430 The FCA`s
sandbox is currently conducting its fourth round of experimentations and has already provided an array of tests
with technologies as DLT, smart contracts, artificial intelligence and peer-to-peer lending.431 Therefore, this
paper states that regulatory sandboxes, as an example of the do no harm concepts, should be considered the
regulatory model to be followed to address the regulatory uncertainty challenge that hinders the application of
DLT to securitisation, especially considering the arguments that will be below provided by this research.
Given the above explained, this paper argues that the implementation of regulatory sandboxes
in line with the principles of do no harm as proposed by Chairman Giancarlo is the most suitable approach for
regulators to deal with the discussed regulatory uncertainty challenge and embrace the case of DLT and
securitisation. To sustain this stance, this paper stems from two main arguments: this strategy could (i) better
satisfy the innovation-regulation trade-off; and (ii) correct the flaws identified in the Wait and See Approach
and the issuance of new regulation. In relation to the first argument, it is argued that regulators adopting
regulatory sandboxes could indeed encourage the development of innovation without its harm (first side of the
trade-off). To support this, the establishment of a sandbox could provide an environment where firms might,
for instance, develop DLT solutions to securitisation with fewer burdens derived from existing regulation,
considering the provision of a flexible legal framework inside the sandbox.432 Therefore, this paper states that,
by allowing this possibility, regulators are taking active actions to promote innovation, since the compliance
with the entire rigid conditions prescribed by laws may stifle the development of DLT, especially in the case of
small-sized firms.433 On the other side of the trade-off, it is also argued that the discussed approach could
observe the objectives of financial regulation. This is because, during the tests inside sandboxes, regulators
must ensure the protection of consumers that participate in this space and the system as a whole434 by
imposing conditions to avoid eventual risks that could rise.435 For instance, the FCA demands firms that aim
to apply to the sandbox to make a proposal for the regulator explaining the means how they will mitigate and
compensate eventual harm to consumers,436 as well as that they consider that the tests must not entail on
harm to the system as a whole.437 Therefore, it seems that these conditions clarify the concern of the UK
regulator with its sandbox to match the stimulation of innovation with the safeguards of consumers and the
428 See Brummer & Yadav (n 93) 54. 429 According to Zetzsche and others (n 98) 26, in August 2017, 14 countries have already created their own sandboxes: the United Kingdom, Hong Kong, Malaysia, Singapore, Abu Dhabi, Australia, Mauritius, Netherlands, Indonesia, Brunei-Darussalam, Canada, Thailand, Bahrain and Switzerland. 430 See Bromberg, Godwin and Ramsay (n 195) 5. 431 See FCA, ‘FCA´s website’ <https://www.fca.org.uk/firms/regulatory-sandbox> accessed 02 August 2018. 432 See Bromberg, Godwin and Ramsay (n 195) 4. 433 See Chiu (n 148) 748. 434 See FCA, ‘Regulatory Sandbox’ (2015) 3, where the FCA recommends that the regulatory sandbox`s structure should provide a flexible framework to firms, but also to ensure that investors are protected. Available at <https://www.fca.org.uk/publication/research/regulatory-sandbox.pdf> accessed 02 August 2018. 435 See Bromberg, Godwin and Ramsay (n 195) 12. 436 See FCA (n 204) 21. 437 ibid 10.
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markets. For these reasons, this paper considers that the do no harm proposal438 based on sandboxing could
better mitigate the trade-off between regulation and innovation.
In addition to the above argued, the potential correction of flaws identified in the Wait and See
Approach and the issuance of new regulation could also justify the thesis of classifying regulatory sandboxing
as an adequate approach for the case of DLT and securitisation. As considered in Section 3, new rigid
regulation that covers DLT, at the current time, could be deemed as an ineffective action that might stifle this
innovation due to the early stage of this technology.439 Thus, it is argued that the use of sandboxes could
provide, at the present time, a framework for innovators and regulators to experiment DLT`s proposals to the
securitisation industry confirming their benefits in order to furtherly verify the necessity or not to change existing
regulation or to issue new legislation in order to embrace this framework.440 In this way, sandboxing could, in
fact, provide flexible rules to DLT and securitisation without harming its development as could occur in the
case of strictly regulating this framework at the present time.441 Secondly, in relation to the Wait and See
Approach, it was previously considered that this approach might fail to provide a higher degree of legal
certainty and to stifle innovation in case of excessive time with this approach.442 Therefore, this paper
supports that regulatory sandboxes could also provide solutions to these failures. This is because the sandbox
approach is based on the establishment of a flexible, but clear legal rules that might be followed by firms that
participate in this environment.443 Put it simply, firms might, in fact, know which requirements to attend in
order to experiment DLT`s innovations to ABS transactions and, in this way, promoting legal certainty to this
environment.444 Moreover, with the exclusive use of a Wait and See Approach, regulators may take time to
provide a clear legal framework to address DLT and securitisation, eventually using ill-suited laws and as a
result harming this innovation.445 To deal with this flaw, it is argued that regulators that take the sandboxing
approach could have time and a space to better understand DLT and their potential application to
securitisation,446 while, simultaneously providing flexible rules that may properly fit the development of
DLT447 and, therefore, timely keep pace with eventual changes and novelties that might arise with this
technology. Hence, from the arguments above proposed, this research sustains that the use of regulatory
sandboxes based on the principles of do no harm is the appropriate regulatory approach to deal with the
application of DLT to securitisation and to address the current regulatory uncertainty. However, this paper
suggests further recommendations linked to the need for international regulatory coordination to complement
the proposed thesis.
Once consistently argued how the do no harm sandboxing could provide a response to the
question proposed by this paper, it seems also relevant to recommend that this strategy might be
438 See Giancarlo (n 176). 439 See Arner, Barberis and Buckley (n 107) 32; see also Deloitte, SFIG and CDC (n 11) 21; and ESMA (n 113) 18. 440 See Brummer & Yadav (n 93) 54. 441 ibid 51. 442 See Finck (20) 13; and Maupin (n 124) 6. 443 See Zetzsche and others (n 98) 26; see also Finck (n 20) 14, Brummer & Yadav (n 93) 51, and Blummont (n 15) 26. 444 See Finck (n 20) 16; and Blummont (n 15) 26. 445 See Maupin (n 124) 6; and Osborne Clarke (n 109). 446 See Finck (n 20) 16. 447 See Zetzsche and others (n 98) 26; see also Finck (n 20) 14; Brummer & Yadav (n 93) 51; and Blummont (n 15) 26.
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complemented with international coordination by regulators in order to fully achieve its purpose. To this end, it
is worth to point out that with respect to new technologies brought by Fintech (as DLT), regulators are taking
different approaches to deal with these innovations.448 However, this lack of international convergence might
weaken eventual actions of national regulators by stimulating circumstances as regulatory arbitrage449 or
hindering innovators that aim to develop DLT financial products in different jurisdictions.450 Additionally, this
situation could also be aggravated by virtue of the nature of Fintech technologies, as well as the current
organisation of regulatory sandboxes. To support this, as a digital platform, DLT is deemed to be a technology
that functions in a global and cross-border form,451 while approaches by regulators are usually provided on
national scale.452 Secondly, the structure of the current sandboxes is limited by their national reach and,
therefore, their rules may vary from jurisdiction to jurisdiction.453 Thus, considering this lack of convergence
and the intrinsic transnational nature of DLT and sandboxes, it is constantly argued that these circumstances
may ask for international regulatory coordination454 between regulators in order to provide an appropriate
framework to embrace the use of DLT in financial activities as securitisation. In this sense, this paper follows
the proposal suggested by Chairman Giancarlo who has already advocated for the promotion of global
regulatory coordination in relation to DLT and financial services through the harmonisation of laws.455 In this
opportunity, he suggested that this coordination process might be performed through the issuance of principles
based on the do no harm approach that should be implemented by authorities into their national, providing
‘flexibility, certainty and harmonisation necessary’456 to allow the DLT framework.457 Once harmonised by
authorities, these principles would provide a worldwide environment for firms to innovate with flexible rules that
could promote innovation in a global scale.458 Thus, in consonance with the proposal of Chairman Giancarlo,
this paper recommends that international organisations as IOSCO should consider the issuance of principles
based on the do no harm, prescribing a flexible legal framework459 to financial innovation (as, for instance,
the one proposed by regulatory sandboxes) in order to provide international coordination. In this context,
through harmonisation of these principles, regulators may allow the creation of a coordinated international
legal framework that could properly embrace DLT and its use in securitisation.
Given the arguments presented in this Section 4, this paper supports the view that there is a
strong legal case for regulators to embrace DLT and securitisation. DLT is a technology that could bring clear
448 See IMF, ‘Fintech and Financial Services: Initial Considerations’ Staff Discussion Notes No 17/05 (2017) 18, <https://www.imf.org/en/Publications/Staff-Discussion-Notes/Issues/2017/06/16/Fintech-and-Financial-Services-Initial-Considerations-44985> accessed 29 March 2018. 449 ibid. For the definition of regulatory arbitrage, see Armour and others (n 129) 565, who define regulatory arbitrage as a tendency by firms to search for jurisdictions with relaxed regulations to provide their activities. 450 See Lev Bromberg, Andrew Godwin and Ian Ramsay, ‘Cross-Border Cooperation in Financial Regulation: Crossing the Fintech Bridge’ (2018) Capital Markets Law Journal Vol. 13, No 1 12. 451 See Finck (n 20) 21; and IMF (n 218) 18. 452 See IOSCO, ‘IOSCO Research Report on Financial Technologies’ (2017) 70, <https://www.iosco.org/library/pubdocs/pdf/IOSCOPD554.pdf> accessed 08 August 2018. 453 See Finck (20) 16; and Brummer & Yadav (n 93) 61. 454 See Bromberg, Godwin and Ramsay (n 220) 2; and IMF (n 218) 18. 455 See Giancarlo (n 176). 456 ibid. 457 ibid. 458 ibid. 459 As supporters of this soft law recommendation, Brummer & Yadav (n 93) 61 suggest that eventual international standards related to Fintech activities could be achieved by an international forum between national authorities.
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benefits to the issuance of ABS by providing a higher degree of transparency to this framework.460 As above
argued, these benefits may directly comply with the aim of securities regulation,461 and, therefore, it seems
evident that regulators have indeed consistent legal grounds to consider this technology to securitisation.
Therefore, in order to address regulatory uncertainty related to DLT, it is claimed by this paper that regulators
should take an active approach by working closely with market participants to promote the evolvement of
DLT462 and to better understand how this technology could attend some demands of the securitisation market.
To this end, this paper argues that a desirable regulatory model to allow DLT and the case for asset
securitisation would be based on (1) the principles of do no harm approach, (2) the creation of regulatory
sandboxes, and aligned with (3) regulatory international coordination. Thus, by taking this innovation-friendly,
regulators could provide a more transparent and safer environment for ABS investors and, as a consequence,
give a new hope for the securitisation industry.
460 See generally Deloitte, SFIG and CDC (n 11). 461 See Armour and others (n 129) 62. 462 See Bromberg, Godwin and Ramsay (n 195) 5
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Conclusions
Considering the above argued, this research concludes that there is a strong legal case for
regulators to consider the use of DLT in securitisation. On this point, it is supported by this paper that the use
of regulatory sandboxes based on the do no harm principles, as proposed by Chairman Giancarlo, should be
considered the model that properly addresses the current regulatory uncertainty that hinders this DLT`s
proposal to securitisation.463 This statement stems from the fact that, with this strategy, regulators could better
cope with the trade-off between innovation and regulation464 and provide corrections of the flaws identified in
possible regulatory approaches.465 In summary, in Section 1, this research has described the main features
of DLT and has explained how this technology is currently being considered to redesign the global financial
markets.466 Following this part, Section 2 has demonstrated that inefficiencies in the securitisation process
(lack of proper due diligence and overreliance on CRA) are deemed to be reasons that qualify this kind of
transaction as a ‘causa proxima’ of the Crisis.467 In this way, Section 2 has also elucidated how DLT could
propose solutions to these problematic issues by allowing a more transparent and safer framework for ABS
investors.468 Subsequently, Section 3 has explored the analysis of regulatory uncertainty (i.e. questions if or
how regulators may properly deal with DLT) as a relevant challenge to permit this new environment to
securitisation.469 In this context, Section 3 has critically evaluated possible approaches taken by regulators
to cope with DLT and has concluded that the issuance of new regulation to DLT, at this moment, could harm
its development to financial transactions,470 while the Wait and See Approach fails to provide an optimal
degree of legal certainty.471 In order to answer the question presented by this research, Section 4 proposes
the thesis that the benefits that DLT may bring to securitisation (provision of a more transparent and protected
environment for investors) seem to be in line with the aim of securities regulation and, hence, clarifies the
consistent legal grounds for regulators to accept this technology. Finally, Section 4 concludes that the use of
regulatory sandboxes based on the do no harm principles is considered the most suitable approach to embrace
DLT and securitisation. To fully provide this innovation-friendly proposal, this paper recommends that
organisations as IOSCO to issue principles based on the do no harm concepts in order to harmonise national
laws and to move in the direction of international coordination in order to reach a worldwide environment to
receive DLT and financial transactions.472 Therefore, given the extensively considered by this paper, it
appears that DLT is a promising technology that could dramatically restructure financial activities as known
today,473 including the asset securitisation practice. By allowing this new framework with a flexible approach,
463 See Giancarlo (n 176). 464 See Chiu (n 148) 748. 465 This paper has considered the Wait and See Approach and the issuance of new regulation. 466 See generally WEF (n 5). 467 See Lastra and Wood (n 41) 16-17. 468 See Deloitte, SFIG and CDC (n 11) 18. 469 ibid 21. 470 See Finck (20) 18. 471 ibid. 472 This recommendation is in line with the one proposed by Giancarlo (n 176). 473 See generally WEF (n 5).
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regulators could indeed act as a real ‘partner’ of the market, helping to recover confidence to the securitisation
industry, a financial activity that is recognised to be important to provide funds to the economy as a whole.474
This situation clarifies how technologies of the Fintech field are a reality that could bring significant benefits to
the markets and, consequently, the society as a whole. Thus, regulators might realise that technology is a real
modern phenomenon that must inevitably to be taken into consideration, because the society seems to be in
front of the rise of a new infrastructure that may not only model the future of the global markets, but also, as
commented by the IMF Director Christine Lagarde, because of its ‘potential to improve our lives’.475
474 See Deloitte, SFIG and CDC (n 11) 28; and SFIG (n 68). 475 See Lagarde (n 104) 10.
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