Towards a Common Framework for the Acceptance of DLT Applications in the EU Banking Sector

Over the last decade, applications of distributed ledger technologies (DLT) and crypto-assets have been increasingly observed within the EU financial sector. However, regulatory fragmentation and legal uncertainty have dampened levels of investment and limited scaling cross-border.

This blog, which is based on an extract of my speech given at Sapienza on 16 December 2020, provides an overview of the challenges firms have been facing and the steps being taken to address these challenges, on which further details are provided in my paper.

DLT: Beyond fiction

The starting point is that DLT is no longer a fiction or fantasy; extensive DLT experimentation is underway often in conjunction with digital or crypto-assets.

For example, experimentation has been observed in the context of payments, trade finance, green bond issuance, foreign exchange, securities settlement and compliance procedures. Indeed, in many areas market participants have moved beyond the experimentation phase, as demonstrated by the hugely successful Spunta DLT initiative which has transformed the interbank reconciliation process in Italy.

However, relatively limited scaling has been observed to-date, particularly in a cross-border context where some of the potential for efficiency gains is at its greatest.

Challenges to scaling

So what is limiting scaling? Five key challenges have been identified:

First, firms seeking to pilot DLT and crypto-asset applications sometimes encounter varying levels of openness among supervisory authorities toward experimentation and inconsistent steers as to supervisory expectations (eg on operational resilience)—both hugely problematic where a firm intends to roll out an application at scale.

Second, firms are facing challenges in identifying applicable regulatory requirements, a point particularly relevant in relation to crypto-asset activities where the majority of activities fall outside a (currently in force) common scheme of EU regulation and may be subject to different regulatory requirements at the national level.

Third, some areas of regulation at national or EU level have been found to inadvertently impede the use of DLT by including specific risk management requirements that reflect perhaps more traditional procedures, for example ‘book entry’ requirements for securities. Some jurisdictions such as Italy have been quick to adopt legislative measures to help recognise DLT and smart contracts as having specific legal effects or recognition for specific purposes but others lag behind.

Fourth, and well known, are issues relating to the reconciliation of DLT with data protection law. As observed by the European Data Protection Supervisor, national data protection authorities have been cautious about expressing opinions, leaving firms again exposed to the challenge of grappling with potentially divergent approaches at national level.

Fifth, issues relating to the applicable governing law have arisen in the absence of clear international norms—a situation that presents a considerable level of legal uncertainty and insurmountable barrier for many regulated firms.

Overcoming the challenges

To overcome these challenges a range of tools are being deployed at EU level.

Reflecting on the legislative steps, in September 2020 the European Commission, based on the advice of the European Banking Authority (EBA) and its sister authority the European Securities and Markets Authority, presented its Digital Finance Strategy accompanied by legislative proposals for new regulations on markets in crypto-assets (MiCA) and a pilot regime for blockchain experimentation by operators of market infrastructure (the pilot regime).

MiCA is intended to overcome many of the challenges highlighted by:

• creating a sound legal framework that clearly defines the regulatory treatment of crypto-assets that do not currently fall within the scope of EU financial services law;
• establishing a consistent, safe and proportionate framework that enables services to be provided cross-border in accordance with common rules;
• instilling appropriate levels of consumer and investor protection and market integrity; and
• ensuring financial stability by addressing risks in a consistent manner across the EU, including in relation to so-called stablecoins.

Four new categories of regulated activity are proposed, each with ‘passporting rights’:

• crypto-asset service providers (eg custodian wallet providers and exchanges);
• issuers of: asset-referenced, e-money and other tokens (each with bespoke regulatory requirements and, in relation to issuers of ‘significant’ asset-referenced and e-money tokens, a proposal for EU level supervision).

The pilot regime, on the other hand, is intended to facilitate DLT experimentation in the EU securities and markets sector by providing a common (and time-limited) framework that enables, where appropriate and necessary, the disapplication of EU law that could otherwise impede experimentation by operators of ‘DLT market infrastructure’ (defined in the proposal as a ‘DLT multilateral trading facility’ or a ‘DLT securities settlement system’). By so-doing it is intended to facilitate the identification of any areas of EU securities and markets law that pose potential obstacles to DLT and crypto-asset application and, as appropriate, the steps necessary to address these issues.

As for non-legislative actions, a range of steps are being taken to promote greater consistency between supervisors as to the acceptability and compliance expectations regarding DLT applications in the financial sector. For example, the ESAs are stepping up their efforts to promote knowledge sharing between national competent authorities, leveraging innovation facilitator initiatives such as the recently launched Milano Hub, which have been shown to be hugely successful in bridging industry and supervisors and promoting a common understanding about risks and opportunities presented by innovative technologies.

Finally, as with other innovative and inherently borderless technologies, the EU authorities are contributing to DLT and crypto-asset work underway at the level of the international standard-setters.

Overall, these efforts are intended to facilitate a common approach to the acceptability, supervision and regulation of DLT applications in the EU banking sector and, more generally, ensure the regulatory and supervisory framework remains technology neutral and fit for purpose for the digital age.

Elisabeth Noble is a Senior Policy Expert at the European Banking Authority.

The views expressed in this blog are mine alone and should not be taken to represent those of the European Banking Authority (EBA) or to state EBA policy. Neither the EBA nor any person acting on its behalf may be held responsible for the use to which information contained in this publication may be put, or for any errors which, despite careful preparation and checking, may appear.