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Crystal test podcast Article08 Mar 2021

Enabling Digitalization in Europe

Europe is looking to create a regulatory framework to support the growth of digital assets

Europe is looking to create a regulatory framework to support the growth of digital assets

The financial services industry is going through a major digitalization process and adopting new innovative technologies, as it looks to improve client experiences and support emerging asset classes. During this transformative period, regulators cannot afford to play catch-up. Instead, regulators will likely need to develop intelligent rules that safeguard market stability and facilitate investor protection, while ensuring that innovation is not stifled. It is a delicate balancing act that the European Commission is attempting to strike with its Digital Finance Package, a set of reforms aimed at turning the European Union into a global leader in digital assets. If the legislative process goes smoothly, the Commission expects these regulations to be in place by 2024.

Supporting the Digital Ecosystem

In addition to introducing flexible and harmonized European wide regulation overseeing new technologies such as Distributed Ledger Technology (DLT) and artificial intelligence , the proposal also looks to provide clarity for the burgeoning digital asset market. Right now, regulatory oversight of digital assets is considered to be fragmented. However, a number of EU regulators – including those in France, Germany and Luxembourg, are taking a progressive approach by simplifying and clarifying the rules around digital assets. For instance, Germany and Luxembourg both recently passed new legislation paving the way for digital securities to be transacted on DLT. With many industry figures attributing the relatively low levels of digital asset issuances to the ongoing regulatory uncertainty, a common supervisory approach is a positive development.

A standard definition of digital assets is important, especially if more financial institutions are to embrace this new asset class. Widespread skepticism about the virtues of crypto-currencies along with general risk management concerns have often inhibited institutions from incorporating tokenized securities into their portfolios. A key element of the Commission’s Digital Finance Package proposal is the Markets in Crypto Assets Regulation (MiCA), which would create a standard definition for digital assets as being either unregulated, for things such as some crypto-currencies like Bitcoin, or regulated, like tokenized securities. Under MiCA, regulated digital assets will be subject to existing requirements such as the Markets in Financial Instruments Directive  (MiFID) and the Central Securities Depositories Regulation. That these assets are subject to prudential regulatory supervision will provide a degree of comfort for institutional investors.

To help market participants familiarize themselves with DLT, the Commission also intend to create a pilot regime or ‘sandbox’ for Financial Market Infrastructures (FMIs) trading and settling digital assets, namely transferable securities as defined under MiFID. Under the provisions, licensed investment firms and regulated market operators will be permitted to establish DLT-enabled multilateral trading facilities (MTFs) in the experimental sandbox, while authorized Central Securities Depositories (CSDs) can develop DLT-based securities settlement systems. Any MTFs or CSDs looking to leverage the sandbox regime must be compliant with MiFID and CSDR respectively. However, there are exemptions to this, most notably around CSDR recordkeeping. Whereas CSDR normally requires transferable securities traded on an MTF to be recorded in book entry form before the settlement date at a CSD, the pilot regime permits DLT MTFs to record transactional information on a DLT infrastructure.

Sandboxes can enable innovation to flourish while helping to ensure that consumers, together with market integrity and stability, are protected. Nonetheless, regulators should spell out clearly what the governance framework will be for FMIs participating in this sandbox. For example, in a DLT ecosystem, it is important to understand how network governance and rules are enforced and what entities are responsible for which functions. A strong digital identity solution will also need to be agreed upon and widely adopted, in order to ensure that participants in the digital chain are fully accountable for their actions.

Mitigating Operational Risk in a Digital Ecosystem

While digitalization and innovative technologies can usher in new opportunities, there is also potential for them to create new risks. This is something which the EC is acutely aware of. As a result, the Commission is proposing a Digital Operational Resilience Act (DORA), which is expected to introduce a standardized regulatory approach towards digital risk management. DORA will likely require financial institutions to have measures in place to mitigate cyber and digital risks. It is also expected to introduce an oversight framework for information and communication technology providers, including those offering cloud services. These obligations may help financial institutions navigate the growing risk of cyber-crime and have been well received by the industry. However, these proposals do pose challenges. While the rules apply to a wide range of financial institutions, some have argued that DORA’s provisions are incredibly complex and will take a long time for impacted financial institutions to properly digest and implement.

Next Steps to the Digital Future

Following public consultations in December 2020, we expect the Commission will prioritize the Digital Finance Package as it looks to lay the foundations for a more innovative and competitive EU financial market.

Any regulations in this area should seek to promote standardization, encourage interoperability across different solutions, and reduce market-wide risks; but should also aim to avoid acting as a barrier to innovation. It is also important that regulators focus on overseeing the activity or entity leveraging the technology, as opposed to the technology itself. If the Commission implements its Digital Finance Package correctly, then it will likely enhance Europe’s competitiveness and innovation in the financial sector making it a leader in the digital assets space. The industry as a whole should aim to engage with regulators to ensure that the rules are sensible, thereby helping the EU in its efforts to become a digital asset powerhouse.

This piece originally appeared in Global Investor on 04 March 2021

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