Governing the Digital Finance Value Chain in the EU: MIFID II, the Digital Package, and the Large Gaps between
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The emergence of the complete digitization of the financial services value chain has gathered pace with the advent of the Covid-19 pandemic. It is mainly premised on automation of the investment process through the use of algorithmic tools and remote delivery of services via integrated platforms and apps. During the same period, we have witnessed the emergence of decentralised finance, cryptocurrencies aside, and the increased use of blockchain technology. Together, these developments promise radical changes in market structure and microstructure.
In our recent article, published in the European Company and Financial Law Review – Special Volume titled ‘Digital Finance in Europe: Law, Regulation and Governance’, we argue that the transformation of the marketplace and of the finance value chain is manifested today through two radically opposing models of financial services infrastructure integration. The first is represented by the increasing domination of the financial services infrastructure by very large institutions like the American asset manager BlackRock, which operates the infrastructure service Aladdin, and the Chinese powerhouse Ant Financial. The second is represented by the impetuous rise of decentralized finance (‘DeFi’), even if for now it operates in the alternative finance space and is mostly fuelled by peer-to-peer lending or financial contracting that uses cryptocurrencies as collateral. The emergence of DeFi employing blockchain protocols is the first step towards a market infrastructure leap that will merge financial contract trading and trade settlement and possibly at a later stage investment advice and order execution, which are today regulated as distinct services. DeFi has the potential to act as a catalyst for the creation of liquid pan-European retail capital markets and market integration, widening access of SMEs and start-ups to capital markets finance, and fostering capital market innovation.
Nevertheless, the regulatory landscape in the EU is still dominated by the older MiFID II approach to market regulation. MiFID II governs the provision of investment services in financial instruments. MiFID II does not directly regulate platforms, but the different functionalities offered by platforms do fall under the ambit of MiFID II. Furthermore, MiFID II imposes a series of product governance requirements on firms manufacturing or distributing financial instruments. In our article, we undertake a review of the existing regime to identify potential gaps that have already arisen through the digitization of the finance value chain and the regulatory dilemmas that will arise in the future, especially in the context of DeFi platforms. For instance, we argue that in the event that DeFi platforms employing automated market maker protocols (‘AMMs’) offer trading services in MiFID II financial instruments, then AMMs may be regarded as systematic internalisers (‘SIs’). But this would place serious limitations on the function of automated market makers on DeFi platforms. Furthermore, if DeFi platforms started acting as ‘distributors’ of MiFID II financial instruments they would find it hard to comply with the product governance regime and both platform members and regulators would have to show willingness to evolve the regime without diluting investor protection. We suggest that one way to do that is if DeFi platforms have an onboarding process for new financial products that are approved and validated only if it can be shown that the ‘manufacturer’ of the product and the ‘distributor’ have already complied with the MiFID II requirements. In any case this is a wider problem that will have to be resolved at some point if DeFi products are to come under the MiFID II regulatory umbrella, since some of these products may not even have an identifiable ‘manufacturer’. Another major challenge is compliance with conduct of business rules on a DeFi platform. For example, there is the question of who discharges conduct of business duties under the MiFID II regime if neither the platform nor the counterparty is authorized as an investment firm.
EU Regulation has to become more proactive fostering regulatory experimentation in tandem with technological one to make sure that consumer interests are safeguarded, competition is furthered, and essential finance infrastructure is not dominated by a tight rent-seeking oligopoly. The EU Digital Finance package in its present form, which includes a Digital Finance strategy, a Retail Payments Strategy, legislative proposals on crypto-assets and digital operational resilience, and a pilot regime for market infrastructures powered by distributed ledger technology is a welcome yet timid step forward. We argue that a number of further reforms, including widening the proposed distributed ledger technology pilot regime to include DeFi platforms which would not hold an authorization as a MiFID investment firm, are required to accelerate the pace of regulatory adaptation to the challenges and opportunities of the new digital era for European markets strengthening post-Covid 19 economic recovery.
Emilios Avgouleas is Chair in International Banking Law and Finance at the University of Edinburgh and Visiting Professor at the School of European Political Economy, Luiss Guido Carli.
Alexandros Seretakis is Assistant Professor of Law (Capital Markets/Financial Services) at Trinity College Dublin.
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