There’s a distinct lack of detail or examination of the current proof-of-concepts and a real lack of nuance around what is still a fairly nascent, yet comprehensive, technology.
Perhaps we shouldn’t be surprised. ESMA has a lot on its plate right now with MiFID I. So where, with its limited resources, it would find the time to thoroughly research DLT, let alone assess its market implications is questionable.
Odder still, is how ESMA seems to have completely ignored a research report issued this past year by the UK Government Office for Science, penned by the UK Government’s chief scientific adviser, praising the technologies’ potential and recommending real-life adoption. Most notably, when compared to the opinions coming from other regulators like the US Commodity Futures Trading Commission (CFTC) or the Monetary Authority of Singapore (MAS), ESMA feels out of step with its contemporaries globally.
The issues described throughout come across odd considering that markets globally are looking towards technology to remedy where man can’t or won’t help himself.
Some excerpted examples:
36. ESMA believes that DLT might facilitate the dissemination of errors, unless a number of checks are implemented.
Joshua’s take: Risk to fair competition and orderly markets.
37. This could drive some firms out of the market and lead to a monopoly-like situation with negative consequences on the cost and quality of the services.
Joshua’s take: In respect to the former, wasn’t this both a driver leading to and resulting from the European Market Infrastructure Regulation (EMIR)? For the latter…recent LIBOR scandal anyone?
The conclusions ESMA draws from this cognitive path, specifically that it is too early to regulate, are illogical assertions to begin with.
Is it feasible, let alone desirable, for ESMA to ‘regulate’ any technology or how it’s used, beyond the auspices of insider trading, market fixing, or investor protection?
It’s no wonder ESMA’s other recent paper around technical standards and guidelines for financial organisations is vague throughout, thus spurring on technical risk, the same risk it is meant to prescribe mitigation towards and monitor.
There is a danger we must all keep in mind; by reining in current activity within a regulatory framework you run the risk of stifling market fairness and limiting innovation adoption.
This could theoretically force our markets into ending up as weaker, sub-standard versions of their existing infrastructures, forcibly maintaining rapidly more arcane processes on old technology stacks while other markets advance in respective leaps and bounds, growing capital and profitability while limiting illiquidity and destabilising industry risks.
It not just weakening from a competitive perspective, it’s exponentially weakening from an architectural perspective.
Fear of all fears
It’s true that any market would theoretically benefit from sufficient time to test scenarios and ideas in different asset classes and get all participants from the buy-side, sell-side and regulators comfortable that it can manage these processes, but it’s not realistic. And it’s never been the driver behind meaningful change, growth, or market protection.
Trader’s trade, technologists innovate, regulators penalise and safeguard. That ESMA’s paper offers less around the technological benefit or hurdles to market adoption than it does about the hypothetical fears of adoption is presumably one of the reasons ESMA also concludes DLT won’t replace CSDs / CCPs, at least in the medium term. Not that anyone has seriously suggested it could or should.
However, the fear of all fears, that the buy-side will trade with each other and not need the sell-side anymore, is a concern best left solely to the banks. Although when you think of the technology, certain use cases such as trade repositories just make sense.
It’s real-time and omni-directional. It’s more predicated by the act of submitting information via reporting rather than the validity of said information or gaining an understanding of said information within the context of a given company or the broader market. It’s predicated by endless reconciliations and data transformations.
With a distributed ledger framework applied, it would evolve from something that is inherently batch-processing and reconciliation-based to something that is functionally far more real-time and verification / synchronisation-based, not to mention flexibly permissible, more secure, and utilising the power of consensus.
Something with actual insight that could be effectively overseen and actioned by a regulator with a meaningful timeliness and shared easily with other regulators across the G20. Further complimenting with a robust framework of oracles, nodes, and smart contracts would create a new approach to regulatory oversight where processing and reporting are neutralised and the focus would be rightfully put on analytics and the monitoring of actual risk.
Better yet, we could escape the required incremental improvements required to the system we have today and regulations we’re moving to tomorrow, whether in the UK or beyond. DLT would allow for the creation of a real-time process where all participants are connecting and collectively verifying each other’s books of record; thereby lessening security and stability concerns with current technologies, lessening the role of the regulator, neutralising the need for the current-state definition of a trade reposition, and vastly increasing transparency while doing away with verifications, reconciliations, affirmations, and even faxes (remember those? They’re still here).
This is all not to say DLT is a silver bullet for more fundamental structural issues in the market. But it is to say, my goodness, if we’re going to be wholly theoretical, let’s at least play a role in evolving and strengthening a market above and beyond the negative potential inherent in any new system, technology, or process.
The work being pioneered by Nasdaq in its proof of concept with the government of Estonia, Singapore’s focus around insider trading, and the DTCC’s recent announcement of a large scale pilot to ‘re-platform’ the existing Trade Information Warehouse and their housing of industry-wide Credit Default Swap data (above and beyond their other previously announced Repo-related Blockchain project), are milestones in an overall, far-reaching discovery process.
Using DLT to provide greater transparency in trade information could be a huge win; players like DTCC, given their role, are mindful of any impact they might have on the wider industry. Their interest says something about Blockchain and how it should be embraced in exploration as opposed to intellectual exile.
The challenge now will be who will implement a production blockchain that will deliver significant cost and operations savings, broad industry adoption, as well as support more efficient operational processes.
Interestingly, the UK’s Financial Conduct Authority (FCA) has also taken quite a divergent stance from its sister organisation on blockchain.
The FCA’s focus is more so on Bitcoin functionality than distributed ledger. In August of 2016, it announced it was close to approving a small number of firms to begin formally using bitcoin as a cryptocurrency. This is a big step considering virtually no approvals have been granted thus far, and the FCA’s stamp is required for local companies to utilise Bitcoin as related to payments and settlements.
This would implicitly lead towards further usage of distributed ledger and other value elements of Blockchain as a major driver behind the desire to utilise Bitcoin, isn’t just the advent of a new currency, but because of expectation of massive savings in the payments and post-trade settlements across B2B, P2P, and beyond.
They’ve more recently just released in April 2017 a full-scale consultation paper on distributed ledger technology, noting that although considerations related to regulation, competitive interests, and operational processes are still to be vetted, the overarching functionality clearly holds much evolutionary potential.
Further, it notes that these potential benefits are still somewhat as-yet-unknown and goes on to differentiated values related to Bitcoin, payments, smart contracts, insurance, and distributed ledger, but promising nonetheless. They also touch upon more broad-reaching questions related to permissioning and crypto-currencies.
Related to regulation, they preach consideration and understanding and specifically note herein:
“We may, therefore, need to consider whether our rules prevent or restrict sensible development that would benefit consumers and hence whether changes may be needed,” and that the FCA does not see a “clear need to consider changes to our regulatory framework for blockchain solutions to be implemented” at this stage.
At the end of the day, DLT allows us to imagine a world where post-trade activity could become a series of smart transactions and automated processes that, by default, remove unnecessary steps, systems, and cost. However, the unchecked, misinformed fears of regulators like ESMA related to the perceived complexity of these processes could mean that they will slow adoption and the success needed for the industry to survive, let alone thrive.
Evolve; finance is nothing if not Darwinian. The fundamental law of nature is anything not growing is dying.