The European Securities and Market Authority (ESMA) has recently published a Discussion Paper titled ‘The Distributed Ledger Technology Applied to Securities Markets’. The basic premise of the paper is to overview distributed ledgers, better known as blockchain technology, and whether it has a place in bringing efficiency to the securities market.
Although many have questioned the use case of bitcoins and other digital currencies, the underlying distributed ledger system of the blockchain that powers bitcoin transactions has gained much appeal among financial market participants. Specifically, with markets representing fractured groups of participants traded countless numbers of products, adoption of a distributed ledger could be used to create a shared reporting, clearing and settlement database system to increase efficiency.
In their paper, ESMA stated that it is of the view that “initially the distributed ledger technology will primarily be explored for post-trading activities, i.e., clearing, settlement, and securities servicing”. In terms of areas of interest for ESMA, specifically cited were European Market Infrastructure Regulation (EMIR), the Settlement Finality Directive (SFD), Central Securities Depositories Regulation (CSDR) and Markets in Financial Instruments Directive (MiFID).
Areas of value
In the ESMA paper, several main areas were pointed out as opportunities for blockchain technology to provide value.
Clearing and settlement: The paper stated that the technology could “speed the clearing and settlement of certain financial transactions, by reducing the number of intermediaries involved and by making the reconciliation process more efficient.”
Record keeping: Distributed ledgers were also cited as providing value for record keeping of ownership of assets.
Oversight: By putting in place an agreed upon reference value framework for all assets reported on a distributed ledger, ESMA added that this would improve oversight for regulators. (For EMIR, this is a specific benefit as the current structure incorporates a common unique trade identifier (UTI) system, but there is a lack of harmony for accessing information between trade repository databases.
Counterparty risk: The paper explained that a distributed ledger “could shorten the settlement cycle of the transactions, which means that each party would be exposed for a shorter period of time to the risk of default of the other party”.
Collateral management: With new rules following the global financial crisis raising minimum margin requirements of different assets, collateral management has become a greater issue for banks and prime brokers. As such, blockchain technology could help by speeding up transaction reporting times and thereby shorten the collateral period needed to hold specific positions.
Why is this important for EMIR regulation?
In relation to EMIR, blockchain technology has the potential to streamline the reporting requirements facing firms. Having been put into effect in 2014, EMIR regulation created reporting required of over the counter (OTC) and exchange trade derivatives (ETDs) for European firms (more on EMIR). Despite being in place for over two years, EMIR compliance remains a difficulty for many tens of thousands of financial and non-financial companies.
At the heart of the difficulties of reporting for EMIR is the requirement for companies to re-format their internal trade reports to information required by ESMA. While on the surface this would seem as a simple ‘data mapping’ issue to solve, it becomes more difficult as companies face the need to unify reporting standards for external and internal trading platform records, data from counterparty systems and records from central clearing parties (CCPs).
Adding to this complexity is the lack of available members from ESMA to turn to for support about ambiguous trade records and questions that arise from new trade scenarios. The result is that an estimated greater than $1 billion has already been spent by firms to implement reporting process to comply with the laws (how firms are reducing EMIR related expenses).
Through the blockchain, the technology's promise is that it could put in place a structure to uniform the overall reporting process. By implementing such a format, reporting information would become much more transparent and easier to cross examine for market participants and regulatory bodies.